ReinforcingtheEurozoneandProtectinganOpenSociety

MEZ22016

GIANCARLOCORSETTI,LARSFELD,RALPHKOIJEN,LUCREZIAREICHLIN,RICARDOREIS,HÉLÈNEREY,BEATRICEWEDERDIMAUROWITHTHEHELPOFFERDINANDOGIUGLIANO

Acknowledgements

WewouldlikethankAurelioMaccario,JasperMcMahon,RichardPortesandJerominZettelmeyerforexcellentcommentsallalongthisproject.

WeareextremelygratefultotheTommasoPadoa-SchioppaChairattheEUIforfinancialsupportandfororganisingseamlesslytheFebruary5thConferenceatwhichthedraftreportwasdiscussed.WebenefittedimmenselyfromtheinsightfulcommentsofparticipantsattheConference.

FurthermorewethankthankparticipantsatseminarsandworkshopsattheECB,theGermanMinistryofFinanceandtheLondonBusinessSchool.

WethankFerdinandoGiuglianoforhisexcellenteditingandmakingusclarifysomeobscuresentences.WearealsogratefultoCEPRforhostingsomeofourdiscussionsandAnilShamdasaniforthefinaleditingofthise-book.

ReinforcingtheEurozoneandProtectinganOpenSociety

MonitoringtheEurozone2April2016

“Ilnousfautdel'audace,encoredel'audace,toujoursdel'audace».

Danton,2Septembre1792.

Introduction:

AcriticaljuncturefortheEuroareaandtheEuropeanUnion

ThesovereigndebtandtherefugeecrisesprovethatEuropehasfailedtodesigninstitutionsrobustenoughtoweatherdifficulttimes.Thestakesarehigh:wheneconomicshocksandpoliticalcrisescoincide,theriskofdisintegrationrisestoalarminglevels.Coordinatedactionsareneeded,butthesearedifficulttoimplementbecauseofthepoliticalclimate.Inshort,wemaybecontemplatingtheendofEuropeasweknowit.

BuildingontheMEZ1project,ourgoalistoproposeinstitutionalchangesthatcanhelptorestoregrowthandprosperitywhilebeingpoliticallyfeasible.UnliketheFivePresidentsReport(EU2015)andotherrecentproposals,whichsuggestprogressivestepsaimedatachievingaclosereconomic,financial,andpoliticalunioninthemedium/longterm1,weproposealimitedsetofmeasureswhichcanbeimplementednowwithoutrequiringbigstepsinpoliticaloreconomicintegrationforwhichthereislittleappetitetoday.This,ofcourse,doesnotmean

1SeeforexampleVilleroydeGalhau(2016)whoproposesthecreationofaEuroareafinanceministerbackedbyalegitimacy-enhancingappointmentprocess;agenuineTreasuryadministration;andastrongdemocraticcontrolovereuroareaaffairs.

thatwedonotconsideramoreambitiousplandesirable.Rather,ourapproachismotivatedbyasenseofurgencyandbyourassessmentthatmajorchangestowardsrapidintegrationwouldrequirealongtime,andperhapstoolongtomaketheeuro-zonesecurenow.

Thecentralideaofourreportisthatasovereigndebtrestructuringmechanismfortheeuro-zoneisamajormissingelementofitsfiscalarchitecture.Inthelong-run,wethinkthatafiscalandfinancialarchitecturethatenforcesdisciplinelessbytargetsfordebtanddeficits–nomatterhowflexible–andmorebymarketmechanisms,wouldbemorerobustandmorecredible.Tomakethisobjectiverealisticwithoutmajorcosts,intheshort-run,thecountriesoftheeuro-zoneneeda“deal”toredistributetheburdenoflegacydebtovertimeandtoaminimumextentacrosscountries.Althoughweconsidersuchredistributionasaconditionforfinancialstabilityandappropriatemacroeconomicadjustment,theproposed“deal”doesnotrequiredebtmutualisationorajointdebtguarantee.

Onthesecondmajorchallengeofsecuringcommonbordersandintegrationofrefugees,wearguethataprojectbondguaranteedbyallcountriesoftheEuropeanUnioncanbemotivatedandpromotedoneconomicgroundsgiventhatthecostsoccurnowwhilethebenefitswillrealizeinthefuture(intermsofpeaceandnewproductiveEuropeancitizens).AstherewillbeEurope-widegains,itisnaturaltofundthesecoststhroughanEU-wideinstrument.

Threecoreproblems

Weidentifythreekeyproblemsonwhichwechoosetofocus.Whilewerecognisethattherearemanyotherimportantissuesatstakeincluding,forexample,thequestionofdemocraticlegitimacyofEUinstitutions,webelievethethreeproblemsweidentifyhavethegreatestpotentialtocausethepoliticalandeconomicdisintegrationoftheeuroareaandoftheEU.

• First,wearelivingwithalargedebtoverhang,adirectlegacyoftheglobalandeurozonedebtcrisis.Thisdebtmountainimpairsgrowthandpreventssensiblepolicyactions,forexampleconstraininggovernments’abilitytocuttaxesorraisespendingduringadownturn.Ahighlevelofdebtalsohinderstheeffectivetransmissionofmonetarypolicyandmaycausefinancialinstability.Forexample,theimplementationofthenewbail–inrulestoresolvefailingbanksbyshiftingthefinancialburdentoinvestorsbeforetaxpayerscanprovehazardousinanenvironmentofhighdebt,eveniftheyaredesirablefromanexantepointofview.

• Second,thelinkbetweensovereignrisk(andmorebroadlynationalrisk)andbanksisstillhangingoverourheadslikeaswordofDamocles,despiteprogressmadewiththebankingunion.Thecompletionofthebankingunion,viaacommondepositguaranteescheme,isblockedinpartbecauseofthisissue.

• Third,therefugeecrisisisnotjustahugehumanitariancatastrophe,buthasboostedtheforcesofdisintegrationwithintheEU.

ThesethreeproblemshavethepotentialtodestroyEuropeasweknowit.Conversely,solvingthemwouldhavethepotentialtocreateavirtuouscircleofprosperity.Wenowreviewbrieflytheimportanceofthesethreeproblemsbeforediscussingsomepossiblesolutions.

1. Thelegacydebtproblem:withusforalongtime

Considertheeuroareaasifitwereasingleeconomicentity.ThismeansthatitsgrossdomesticproductisthesumoftheGDPsofthe19memberstates;itssovereigndebtthesumofthesovereigndebts;anditsdeficitthesumofallgovernmentdeficits.

Between2006and2010,whenthepublicdeficitoftheeuroareaincreased,theaggregatedebt-to-GDPratioincreased.Conversely,whentheaggregatedeficitdecreased,theaggregatedebt-to-GDPratiodecreased.Thisisexactlywhatonewouldexpect.

After2010,theaggregatedeficitdecreasedyearafteryear.Thequestioniswhether,asonewouldexpect,theaggregatedebt-to-GDPratioalsofell.TheanswercanbeseeninthefollowinggraphtakenfromCaruso,ReichlinandRico(2016).Theaggregatedebt-to-GDPratiokeptgrowingeventhoughdeficitsweresizablyreduced.Thisemphasizesthedifficultytoeliminatethestockoflegacydebtinaperiodofloweconomicgrowth.

Whilethisrelationbetweendebtanddeficitsdiffersacrosscountries,ourmainpointisclearintheaggregatedata:itisveryhardtorundownthelegacydebtfortheeurozoneasawhole.Asaresult,thedebtoverhangisverypersistent.Simplecalculationsshowthatdebt-to-GDPratiosarenotgoingtoreachpre-crisislevelsinthenext10years.

Thedebtoverhangposesbothacute(crisis)risksandchronic(lowgrowth)risks.Largedebtlevelseatupfiscalspaceforanumberofcountrieswhobadlyneedit;theypreventtheadoptionofdesirablereformsbecauseofrisktofinancialstability;theyjeopardizetheimplementationofotherreforms,suchasthebail-inofbankcreditors;finally,theycontributetoblockingthecompletionofthebankingunion.

AsdiscussedextensivelyinMEZ1,apublicdebtoverhangalsoweakenslong-termgrowthprospectsastheburdenofdebtservicingactslikeataxonprivateinvestmentandlabourincome.Uncertaintyaboutthefiscaladjustmentsrequiredtoensuredebtsustainabilityhasadepressingeffectoneconomicactivity.Furthermore,alargedebtexposesacountrytopotentialself-fulfillingdebtcrisesandliquidityproblems.

2. Thebank-sovereignloopproblem:stillathreattofinancialstability

Whileimportantprogresshasbeenmadewithregardtocreatingabankingunion,thesovereign–bankloopisstillaliveandwell.However,theholdingsofdomesticsovereignbondsinthebalancesheetsofeuro-zonebankshaveincreasedduringthecrisis.Theso-called‘homebias’isanaturalresponsetoriskwithinandoutsidetheEurozone.Yet,withintheEurozoneithasspecificcharacteristics,withseveralpossibleinterpretations:thefirstisthatinvestinginsovereigndebtoftheperipherywhilerefinancingattheECBwasa“greatcarrytrade”(seeAcharyaandSteffen(2014))atatimewhenthebanksoftheperiphery,inparticular,neededtoincreaseretainedearningstorebuildtheircapitalbase.Thesecondisfinancialrepression,meaningthatregulatorsandgovernmentsforcedbankstoholdmoresovereigndebtatatimewhenforeignbuyersweresellingthesebonds(seeBeckerandIvashina(2014)).Thethirdismoralhazard:fearingabreakupofthecurrencyunionand/oradefault,thebanksmayhavechosentobetonapossiblepreferentialtreatmentbythedomesticauthoritiesincaseofapartialdefault,orrealizedthat,inthecaseofalargesovereigncrisis,theirfateandthefateoftheirsovereignwashighlycorrelated.

TheissueofhomebiasintheholdingofgovernmentbondsbybankshasrecentlystabilizedbutisstillhighinparticularforItalyandSpain.Thisisaproblemnotjustforfinancialstabilitybutalsoformonetarypolicy,asitsegmentsthecreditmarketacrossnationallines,hinderingthemonetarytransmissionofpolicychanges.Oursolutionwouldhavetheadvantageofputtinginplacetherightincentivesforthecreationofaeurozone-widesafeasset,whichwouldbeusefulfortheimplementationofmonetarypolicytoo.

WepresentaggregateandbanklevelevidenceinChapter2ofthereport.Wealsonotethattheresolutionofthesovereign-bankloopisseenbysomeasaprerequisitefortheimplementationofthethirdpillarofthebankingunion,thecreationofacommondepositguarantee.

3. Therefugeecrisis:anewshockinanalreadyfragilesystem

TherefugeecrisishasputtheEUunderseverestrain,strengtheningthecentrifugalforcesthathaverattledtheUnionsincethebeginningofthesovereigndebtcrisis.Inthefirsthalfof2015,therewerealmostasmanyasylumapplicantsasinthewholeof2014,andthisnumberisdestinedtogrowrapidly,asweshowinChapter4ofthisreport.Therefugeecrisisisfirstandforemostahumanitariancrisis.ThepoliticaldynamicsinvariouscountriesoftheEU,includingtheriseofextremistandxenophobicparties,meanthatwhatintheoryshouldbeamanageableissuebecomesquicklyaforcepushingforpoliticaldisintegration.SincetheproperintegrationofrefugeesisanEU-wideproblem,itrequiresanEU-wideresponse,whichhasnotemergedsofar.

IfwecouldrebuildEuropeanInstitutionsfromscratch…

WehavenowabetterideaofwhattypeofEU-wideinstitutionsweshouldhavetoensurefinancialstabilityandboostgrowth.Ifwecouldstartfromscratch,wewoulddesigneuroareainstitutionsdifferentlyfromwhatwasdoneinthepast.

First,sincedeficitrulesareroutinelyignored,wewouldhaveasovereigndebtrestructuringregime.Thiswouldmakeitimpossibleforpoliticianstosimplyincreasethesizeofpublicdebttounsustainablelevels,creatinganendgameandgivingcredibilitytotheprinciplethatfellowmemberstatesshouldnotbailoutaeurozonecountry.

Buildinginthesystemcommonrestructuringruleshasanotheradvantage:itallowstoenforcedisciplineand,atthesametime,tomanageorderlyadefaultwhenaseriousproblemoccurs.Knowingthisexante,marketparticipantswouldalsopriceriskappropriatelyandnotexpectbailouts.

Therestructuringregimeisofcoursenosubstituteforotherinstitutions,atnationalandeuro-arealevel.Bywayofexample,itstrengthenstheroleofindependentfiscalcouncils,which

wouldnaturallybecalledtodefinethespaceforbudgetinitiativescompatiblewithkeepingdebtinthesafezone.Therestructuringregimecouldalsobeusefullysupplemented,perhapsatalaterstage,byaeurozone-widepublicspendingcapacity.WediscusswhataEurozone-widesovereigndebtrestructuringregimecouldlooklikeinChapter1.

Second,havingobservedtheexistenceofasizeablehomebiasinthebalancesheetoffinancialinstitutionsandacknowledgingthesignificantrisksarisingfromthepresenceofastronglinkbetweenthesovereignandthebanks,wewoulddelinkbanksfromtheirnationalrisk.Thiswouldbeachievedbyimposingoneofthefollowing:i)diversificationviathecreationofacompositeasset;ii)maximumexposurerules;iii)riskweightsonsovereigndebtholdings.Wediscusstheapproachesoffinancialregulationtothebank-sovereignloopandoursolutionsinChapter2.

Third,havingobservedtheweaknessoftheexternalSchengenbordersandthetragicfateofmanyrefugees,wewoulddesignaEU-widerefugeepolicy.SuchpolicywouldrequireincreasedspendingfortheEUagenciesinchargeofsecuringthebordersandonprojectsaimedattheeconomicintegrationofrefugees2.Obviouslythisisacomplexsubjectandwedonotaiminthisreportatproposingacomprehensivepackage.RatherwehavethemorelimitedaimofdesigningaEU-widefinancialinstrumentappropriatefordealingwiththekindofchallengethattherefugeecrisisrepresentsfortheUnion.Wediscusshowthemotivationforitaswellasitsfeaturesarespecifictothenatureoftheshockrepresentedbythiscrisisanddifferfromthebroaderdiscussiononeuro-bondsinthecontextofthefinancialandfiscalcrisisoftheeuro-zone.ThisanalysisispresentedinChapter4.

Theproblemofthetransition

Canwethensimplyproceedtoremodelourexistinginstitutionsasdescribedabove?Theanswerisaresoundingno.Thiswouldbedangerous,asthetransitionpathtowardsanydesiredlongruninstitutionalsettingisoftenhighlytreacherous.Byimplementingregulatorychangeswithoutsolvingthelegacydebtproblemandthinkingverycarefullyaboutthecurrentstructureofthebalancesheetsinthefinancialsectorwewouldsimplycreateaveryunstablesituation.

Imagine,forexample,announcingadebtrestructuringmechanismforhighlyindebtedcountriesinanenvironmentwhereseveralcountriesarealreadyhighlyindebted.Theresultwouldbearunontheirdebt.Alternatively,imagineannouncingtheimplementationofrisk

2Todosoonecouldthinkforexampleofthefollowingactions:i)reinforcingtheEU’sexternalbordersandbuildhot-spotstoidentifyrefugeesrapidly;ii)investinginthecountriesoforiginofthemigrantstosecuresafeandliveablezoneswhereverpossible;iii)designingintegrationpoliciesfortherefugeeswhoareinEurope(languagecourses,qualityhousing,labourmarketopenness).Evenmoreambitious(butalsooutofthescopeofthisreport),wouldbetoworktowardsastrongcommonforeignpolicyanddefencepolicy.

weightsonsovereigndebtinanenvironmentwherebalancesheetsareloadedwithgovernmentbondsinsomecountries.Theresultwouldbeabankingpanic.

Oneveryimportantmessage,developedinChapter3,isthatmanagingthetransitiontowardsbetterinstitutionsisessentialandthatthecurrentstartingpointcannotbeignored.Therefore,thesolutiontothisproblemisaquidproquo:weproposeinChapter3acoordinatedone–offsolutiontodealwiththelegacydebtinexchangeforapermanentchangeininstitutions(theadoptionofthefiscalframeworkdescribedinChapter1andoftheaccompanyingbankingregulationframeworkdescribedinChapter2).Themostobviousalternativeapproach–lettingtheECBholdgovernmentdebtboughtviaquantitativeeasingindefinitely–wouldendupplacinganexcessiveburdenonthecentralbank.Conversely,ourapproacheliminatestheriskofmoralhazardlinkedtothecoordinatedeliminationofthelegacydebt.Everycountryendsupinabetterplace.

Onefinalpointisthattheproposalsincludedinthisreportshouldbethoughtofasacomprehensivepackage.Iftherewereinsufficientpoliticalwilltoimplementallofthem,oneshouldbecarefulaboutpickingonlypartsofthisreport.Forexample,onlyimplementingtheideasrelativetothesteadystate,withoutmanagingcarefullyhowonegetstherewouldberisky.

Inanutshell,inthisreport,wearetryingtonavigateatreacheroustransitiontoendupontherightshore.

Thedifferenceayearmakes(forourMEZ1readers)

Thisgrouphaspresentedsimilarproposals(jointandseverally)mostrecentlyintheprecursortothisreport(MEZ1,CEPR2015).Theeventsoverthecourseoflastyear,inparticulartheGreekdebtconfrontation,thestartoflargescaleQE,andtheemergenceofstrongpopulardiscontentwiththeECBinsomepartsoftheEurozone,havevalidatedmanyofourconcerns.Thus,wereiteratesomeofourearlierproposals,developthemandadaptthemtoboththenewworldandourownlearnings.

Theimportanceoffixingthefiscalandfinancialframeworkonsovereigndebtremainscrucial.TheGreekdebtdispute,whichabsorbedalmostallpoliticalcapitalforhalfayear,clearlyshowedthatthecurrentframeworkofdealingwithexcessivedebtisdeficient.Inthemeantime,theIMFhasstrengtheneditsownlendingpolicyandthecasefortheEuropeanStabilityMechanism(ESM)reformisevenstronger.Comparedtolastyear,ourframeworkondebtrestructuring(Chapter1)isnowamendedtoaccommodateconcessionallendingbythe

ESM.WealsosuggesttousethenetpresentvalueofdebtwithafixeddiscountrateforthesustainabilitythresholdsofESMprogramcountries.

Ourproposalfordealingwiththebank-sovereignloop(Chapter2)istheinthesamespiritaswhatwasdiscussedinMEZ1insofarthatitprovidesincentivesforfinancialinstitutionstoholdageographicallydiversifiedbundleofsovereignbondswhichisalsothefirststepforthecreationofaeuroareasafeasset.However,wenowgomuchfurtherinprovidingdetailsonthepracticalimplementationofsuchproposalandwedefinetheseniortrancheofsuchdiversifiedbundleinrelationtotheparametersproposedforthedebtrestructuringregime.Webelievethatthisisthefirstconvincingproposalforthemarketcreationofaeuroareasafeassetintegratedwithinacoherentfiscalframework.

Wehavemodifiedthedebtreductionstrategy(Chapter3)tolightentheburdenontheECBinrecognitionthatQEhasalreadytakenatollonitsriskcapacity.Therefore,wenowfocusonourfiscalrisksharingproposal,whichwehaveupdated.Theotheravenuesfordebtreductiondoremainvalid,however.

Chapter1:

SovereignDebtRestructuringRegimefortheEurozone

Thefirstpillarofthisproposalinvolvesbuildinganeffectivesovereigndebtrestructuringregime(SDRR),whichwouldfulfilthedualpurposeofactingasdisciplineinpreventingsovereigndebtbuildupandcrisesinthefirstplaceandprovidinganinstrumenttodealwithsuchcrisis,shouldtheyoccurnevertheless.OurproposalisanchoredinESMaccesspoliciesandusesthresholdsfordebtandgrossfinancingneedsastriggermechanismsinasimilarfashionaspracticedattheIMF.

Thismechanismcannotbeintroduced,however,unlessapreliminary,one-offsizeabledebtreductionoperationhasbeencompleted(seeChapter3).Anecessarypre-conditionforitsimplementationis,therefore,thatthedebtoverhangwhichstrainsgovernmentshasbeenclearedandthatalleurozonecountriesareoutsidethevulnerabilityzoneweidentifyinthischapter.

1. TheRationaleforaSDRRandProposal

RationaleforanSDRRintheEuroarea

Withoutaneffectiverestructuringmechanisminplace,officiallenderswillalwaysbetemptedtodealwithexcessivedebtwithacombinationof(a)procrastination(kickingthecandowntheroad)and(b)provisionofadditionallendingevenincaseofserioussolvencyconcerns(gamblingforresurrection).Theoutcomeisusuallytheworstofbothworlds:countriesindifficultyhavefacedburdensomefiscaladjustmentprogrammesandundergonesubstantialsocialharm,whiledebtlevelshaveremainedunsustainablyhigh.ThisdescribesthepresentsituationintheEurozoneprettyaccurately.

Thisapproachalsocreatesperverseincentivesontwofronts:countriesindifficultytendtoborrowexcessivelyfromothermemberstates,hurtingEuropeantaxpayerswhentheseloanshavetobewrittendown.Meanwhile,theprivatesectorcontinuestolendtocountriesindifficulty,asinvestorsknowtheywillberepaid,atleastinpart,bydomestictaxpayers.Theresultistheunderpricingofdebtandover-borrowing.

Thus,thecountriesoftheEurozonehaveendedupwithlargeamountsofdebtandwithoutthemechanismsthatwillallowthereductionofthisdebt.Thealternativetothisapproachiscreatingasovereigndebtrestructuringregime.

Inamonetaryuniontheneedforsuchamechanismisevengreaterfortworeasons:First,inamonetaryunion,memberstatesofamonetaryunioncannotcountondevaluationoraccommodativemonetarypolicyeithertofosteradjustmentsotocontaindebtaccumulation,ortoreducethevalueoftheirdebtexpost(debtsustainability).Second,adebtcrisiscanhardlybeisolatedinasinglememberstate,andcanbeexpectedtohavestrongspilloverandbecomeaproblemfortheentirecurrencyarea.Thisisbecauseoftheclosetradeandfinanciallinkagesbetweencountriesand,inparticular,thethreatofthecollapseofthecommoncurrency,whichaffectsinvestorsacrossthemonetaryunion(excessdebtexternality).

TheRoleoftheESM

Asovereigndebtrestructuringregimeisalsoanecessarycomplementtotheeurozone’scrisis-lendingfacility,theEuropeanStabilityMechanism(ESM).Themainprincipleofcrisislendingisnottolendintoinsolvency,sincethiscancreatethekindofperverseoutcomeswedescribedabove.TheESMshouldthereforeonlylendtocountriesthatareconditionallysolvent,meaningthat,onceintheprogramme,theyareableandwillingtoundergotherequiredprogrammeoffiscaladjustmentandstructuralreformandpaybacktheirdebts.Ifacountryfailsthetestofconditionalsolvency,thendebtrestructuringisneeded.

Awell-designedSDRRhasthreecharacteristics.First,itmustdefineinsolvencyviaadebt-sustainabilityanalysis.ThiswillactasgatekeepertoanylendingfromtheESM.Second,itmustdefinetheinstrumentsfororderlyrestructuring.Third,itmustcredibly“tiethehands”oflendinginstitutions,toavoidthattheyrenegeontheprincipleofnotlendingintoinsolvencyonceacountryisindifficulty.

Theproposalinanutshell(SeeMEZ12015)

Toachievetheseobjectives,wedesignamechanismmadeoftwoparts.Thefirstpartactsasthepreventivetool,inthatitcorrectstheexistingexanteincentivestopostponedebtrestructuringindefinitely.Thesecondpartfixesexpostincentives,ensuringthatarestructuringisviablebylimitingthepowerofholdouts.

ThefirstpartthereforeamendstheexistingESMlendingpolicies,insertinghardthresholdsfortheriskofdebtdistress.Weproposethereshouldbetwosuchthresholds:theESMshouldonlylendtocountrieswhentheirsovereigndebtislessthan90%ofGrossDomesticProduct(GDP).InthecaseofcountrieswithpreviousESMprogrammes,thenetpresentvalueofthedebt

shouldbelessthan90%ofGDP.3Theproposalof90%shouldbereadasanattempttobeconcrete:amorecarefulstudycouldpickanalternativenumber,whileleavingourconclusionsunchanged.

Secondly,theESMshouldonlylendtocountrieswhosegrossfinancialneedsarelessthan20%ofGDP.(Againtakethe20%exactfigureasindicativeratherthandefinitive.)Ifanyofthesetwothresholdsarebroken,andthecountrylosesmarketaccess,accesstotheESMissubjecttooneofthefollowingoptions:eitherone-timereprofiling,oradebt-reductionoperation.

Thesecondpartinvolvesdealingwiththe“hold-outproblem”,preventingsmallminoritiesofcreditorsfromfreeridingonarestructuringwhichisagreedtobyamajority.Hold-outsmaythuspreventrestructuringsbyrefusingtoparticipateevenwhentheyareinthecollectiveinterestofcreditors.Therearecontractualremediesfortheholdoutproblems(Collectiveactionclauseswithstrongaggregationfeatures)orstatutorysolutions.WeproposeastatutorysolutionbyinsertingaclauseintheESMTreatythatwouldextendimmunityfromjudicial

3OurproposalistousenetpresentValueofthedebtinlinewithIMFandWorldBankpractice,i.e.usinga5%discountrate.ThereferenceforNPVuseinTheIMF/WBdebtSustainabilityFrameworkcanbefoundathttps://www.imf.org/external/np/exr/facts/jdsf.htm

processtosovereignsthatnegotiatedadebtrestructuringwitha(super-)majorityofcreditorsinthecontextofanESMprogramme(seeCIEPR2013formoredetailedexplanation):

ARTICLE___Immunityfromjudicialprocess“TheassetsandrevenuestreamsofanESMMemberreceivingstabilitysupportunderthisTreatywhichareheldin,originatefrom,orpassthroughthejurisdictionofanESMMembershallnotbesubjecttoanyformofattachment…inconnectionwithaclaimbasedonorarisingoutofadebtinstrumentthatwaseligibletoparticipateinarestructuringofthedebtofthebeneficiaryESMMemberaftertheeffectivedateofthisTreaty.”

DifferencebetweenproposedESMregimeandnewIMFlendingpolicy

Inprinciple,thedifferencesbetweentheproposedESMregimeandthenewIMFlendingpolicyarenotlarge.TheIMFhasrecentlystandardizeditsdebtsustainabilityanalysis(DSA)tool,whichservesasgatekeepertoanylendingbydeterminingtheprobabilityofdebtsustainability.ThethresholdsunderlyingtheIMF’sDSAarethatacountry’ssovereigndebtshouldbelessthan85%ofGDP,whileitsgrossfinancingneedsshouldbelessthan15%ofGDP.Hence,intermsofthresholds,theIMF’spolicyisstricterthanourproposal.Furthermore,asof29January2016,theIMFhasamendeditsexceptionalaccesspolicy:theIMFabolishedtheso-called“systemicexception”,whichmeantitwouldstilllendtocountrieswhichdidnotpasstheDSAwhentherewouldbesystemicconsequencesfortheglobaleconomyandfinancialsystem,whileatthesametimetheIMFintroducedtheoptionofdebtreprofiling,insteadoffull-blownwritedowns.TheIMF,however,didpreservethepossibilitytolendinhighlydoubtfulcaseswithoutdemandinganimmediaterestructuring,providedthattheborrowingcountryalsoreceivesassistancefromotherofficialorprivatecreditorsduringtheprogramme.

Asaresult,theIMFframeworkstillretainsagoodmeasureofdiscretiontodelayrestructuring.OurproposalfortheESM,similarinspirit,howeverreducesthedegreeofdiscretionaswewanttoensuretherightincentivestopreventdebtfromspiralingoutofcontrolareinplace.TheESMproposalisalsostrongerwithregardtoitssecondpart–theoneaimedatimprovingexpostincentives.Ourplanis,infact,treaty-based,whiletheIMFhasmerelyendorsedsomecontractualchangestoreducethepowerofholdouts.

AnotherdifferencebetweenIMFandESM

OnedimensioninwhichtheIMFandtheESMdiffersignificantlyisintheirlendingconditions.WhiletheIMFlendsatmarketratesandforshortmaturities,theESMhasreviseditslendingconditionsrepeatedlyandnowlendsathighlyconcessionalrates:itpassesonitsfinancingcostwithoutadditionalchargesandthematurityofloanshasbeenextendedtoupto30years.

TheimplicationsofthisevolutionoftheESMlendingpolicyhavenotbeenwidelyrecognized.Ontheonehand,theconcessionallendinghasgivenborrowingcountriesasizeableautomaticbuffer,whichsoftensandstretchesthepost-crisesadjustment-path.AnotherwaytolookatitisthattheESMhasaddedquitealargefiscalbuffertothearchitectureoftheeurozone.Ontheotherhand,theconcessionalratesandextremelylongrepaymentschedulescreatesomedisadvantages,inthattheymaygiverisetodebtdependenceandcontinuousrenegotiations.

2.Frequentlyaskedquestions

Wehavereceivedmanycomments,objectionsandquestionstoourproposaloverthelastyear.Someofthemarequestionsofprinciple(“whydoweneedsucharegime?”)othersaretechnicalquestions(“whydoweneedthistypeofrestructuringregime?”)

HerearesomeoftheFAQsandourAnswers:

1. ThereisnoSDRRattheinternationallevel.Whatisdifferentabouttheeurozone?

Whiletheeurozonehasmanycentralinstitutions,includingtheCommissionanditsStabilityandGrowthPact(SGP)andMacroeconomicImbalancesProcedures(MIP),itisunclearwhetheritisbetterthantherestoftheworldatpreventingcrisis.Firstly,theeurozonehasnocentralbudgetandnoautomaticstabilizers.Secondly,ithasahigherriskofcrisisspillover,mainlybecauseofthepossibilitythatinvestorsmayquestiontheirreversibilityofthesinglecurrency.ThismeansthatthequalityofpreventionisabigissueanditdependsonwhethertheSGPandtheMIPactuallywork.

Theeurozonealsohasstrongerincentivestodelayrestructuringbecauseofthelargerexternalitiesandbecausethereisanexceptionallyhighstigmaforsovereigninsolvency.Furthermore,theESMislargerandsofterthantheIMFandthushasagreatercommitmentproblem.Finally,thecomplicationsarisingfromdebtrestructuringareworsethanelsewhere.Forastart,thereislesswillingnesstouseunilateraldebtexchangeoffers.Secondly,theGreekprecedent–wherehold-outswererepaidinfull–isadangerousone.Finally,euro-collectiveactionclausesarenottheanswer,asthereisnotenoughaggregation.

2. ADebtRestructuringRegimewillalwayscreateinstabilitybecauseitweakensthe

sovereignsignature(seeDeauville)

Thiswouldbetrueifcountries’debtlevelswereaboveorveryclosetothethresholds.Howeveriftheyareclearlybelow,theeffectwouldbestabilizingsincethethresholdwouldreducetheincentivetoborrowtoomuch.Assoonasdebtlevelsincreasedtowardsthethreshold,risklevelswouldincreaseandcountrieswouldbecutofffromfinancingatlowerlevels.Butthisisanintendedeffect.

3. Don’thardthresholdsopenthedoorforself-fulfillingruns

Thethresholdsdonotdependonmarketinterestrates,sotheydonotsufferfromtheusualfeedbackloopforrunswherebyperceptionsofinsolvencyaffectmarketprices,whichinturnaffectthethresholdsdeterminingdefault.Atthesametime,whileprivatecreditorsknowthatonce90%willbereached,restructuringwillhappenifmarketaccessislost,thereissomeuncertaintyonhowlargecouldbetheprivatelosses,aswellasonwhetherunexpectedshockscouldpushacountrybeyondthatthreshold.Therefore,wellbeforeacountryisnearthethreshold,marketinterestratesshouldstartincreasing,providingthemarketincentivesthatkeepcountriesawayfromaccumulatingasmuchas90%ofdebttoGDP(thereisalsoaroleforfinancialregulationthatreinforcesmarketdiscipline,asexplainedinChapter2).ThekeytoourproposalisthattheupfrontoperationofdebtreductiondescribedinChapter3lowersthestockofdebtenoughtobringallcountrieswithinthe‘safezone’.’Arestructuringregimewithstrictertermscannotbutstrengthentheroleofmarketdiscipline,makingdebtpricemoreresponsivetofiscaldeteriorationanddebtaccumulation.Increasingratesatlowerlevelsofdebtareanintendedeffectofthenewregime,whichreliesmoreonmarketdiscipline.Finally,theproposalisnosubstitutesforotherinstrumentsandinstitutions,e.g.bankingunionortheroleoftheECBasalenderoflastresort,thatshouldcontaintheriskoffinancialinstabilityviabothexantepreventionandexpostprovisionofliquidityassistance.

4. WhyaDebtRestucturingRegime?Woulditnotbebettertoensurefuturedisciplinethroughstrongfiscalrulesandstrongerpowersatthesupranationallevel?

Inprinciple,thiswouldbeanalternativediscipliningmechanism.However,ourproposalstartedfromthepremisethattreatychangeisnotanear-termoptionandthatthereisinsufficientconsensusformovingtowardfullfiscalunion.

5. WhyshouldthisSDRRbecredible?EvenattheIMFtheframeworkwasregularlybrokenoramendedwhenconvenient.

Thisdoesnotmeanthattheframeworkwasirrelevanttobeginwith.ThebreakingoftheframeworkoftheIMFoccurredatthetimeofthefirstGreekprogramandinvolvedaheateddebateattheIMFboard.TheFundeventuallyrespondedbyamendinglendingpoliciesfortheentiremembershipandbyintroducingthesystemicexemption.ButthissofteningoftheframeworkcontinuedtogiverisetomuchdebateandconcernsaboutthecredibilityoftheFund.InJanuary2016,thesystemicexemptionwasabolishedandthelendingframeworkhasbeentightened.

6. Debtsustainabilityisnotaprecisescience.Itrequiresjudgmentforeachcase.Whyacommonthreshold?Shouldn’titbecountry-specific?

Inprinciple,theunobservedrealborderbetweenilliquidityandinsolvencyisprobablycountry-specificandmayevenvaryovertime.However,thisindeterminacywouldopenthedoortodiscretion,anddebtrestructuringisanareawherepoliticalinterferenceandtimeinconsistencyareverysignificant.Officiallenders(oflastresort)needaframeworkthattheycanapplyconsistentlyacrosstheirmembership.

AttheIMFonedistinctionisapplied,namelybetweenlow-incomeandmarket-accesscountries.Theformerhavelowerthresholdsfordebtsustainability,thatarealsolinkedtotheinstitutionalqualityasassessedbytheWorldBank(seetablebelow).FortheESMthiswouldnotbeafeasibleapproach.Firstforallitsdifferences,theEurozoneisamorehomogenousblock.Second,itwouldhardlybepoliticallyacceptabletoassignlowerlevelofpermissibledebtandfinancingneedstocountrieswithaweakerinstitutionalquality.TheEuropeanapproachhasalwayssupposedequaltreatment.

Thereisatradeoffbetweendevisingthemostcorrectassessmentofsustainability,whichseemsimportantonceacountryisinthegreyzoneofvulnerability,andfixingincentivesinsuchawaythatcountrieswillnotevengetintothatzone.Ourstricterframeworkputsagreaterweightonthepreventivefunction,whichisparticularlyimportantinamonetaryunion.(SeeQuestion1).

7. Areyounotcreatingincentivestomovedebtoffbalancesheet?

Theincentivestomaskagovernment’s“true”fiscalpositionalreadyexistforvariousreasons.Window-dressingmaybeattractiveforpoliticalreasons,ortocircumventEuropeanrules,suchastheSGP.ThisiswhyitisimportanttohaveastrongandindependentEuropeanstatisticalagency,withpowerstooverseenationalagencies.TheSDRRreinforcesthiscase.

8. Whythesespecificthresholdsof90%Debt/GDPand15%GFN/GDP?

Wearrivedatthesethresholdsintwoways.Thefirstispragmatic:addingasubstantialbuffertothe60%baselineDebt/GDPratiousedinMaastrichtandcheckinginhistoriccrisiseventshowlargetheeffectivebufferswere(seeCIEPR2013).Thesecondisanalytical:theIMFandtheEUhavederivedtheirthresholdsfromearlywarningmodelsthataresimilartoours(seeTableXbelow.Wehaveaddedanadditionalbuffersinceourthresholdsarehard.

Table1:Thresholdsinvariousframeworkstoassesstheriskofdebtdistress

Source:SchumacherandWederdiMauro(2016)“DiagnosingGreekdebtsustainability:Whyisitsohard?”,BrookingsPapersonEconomicActivity,Fall2015Conference

European CommissionEU member states

Advanced economies Emerging marketsWEO convention WEO convenction

Policy-rating90% 85% 70% Weak 38%

(face value) (face value) (face value) Medium 56%Strong 74%

Gross financing needs 15% 20% 15%Debt profile

Bond spreads < 231 - 276.6 < 400, < 600, > 600 < 200, < 600, > 600 -External financing requirement/GDP < 17%, < 25%, > 25% < 5%, < 15%, > 15% -

Foreign currency debt/Total debt 29.82% - < 20%, < 60%, > 60% -Non-resident-held debt/Total debt 49.02% < 30%, < 45%, > 45% < 15%, < 45%, > 45% -

Change in short-term debt 2.76 < 1, < 1.5, > 1.5 < 0.5, < 1, > 1 -PPG external debt/GDP - - - Weak 30%

Medium 40%Strong 50%

PPG external debt/exports - - - Weak 100%Medium 150%Strong 200%

PPG external debt/revenues - - - Weak 200%Medium 250%Strong 300%

PPG external debt service/exports - - - Weak 15%Medium 20%Strong 25%

PPG external debt service/revenues - - - Weak 18%Medium 20%Strong 22%

Debt/GDP

IMFMarket-access countries Low-income countries

Low-income countriesPRGT-eligible, PPP GDP

< USD 1,195

(present value)

Chapter2.Steady-statefinancialregime:Delinkingthebanksfromsovereigns,inparticularfromtheirown.

InMEZ1weproposedachangeintheregulatoryregimeforthetreatmentofsovereignbondsheldbyfinancialinstitutions.Ourproposalhadtwoaims:

(i) Encouraginggeographicaldiversificationintheholdingsofsovereignbondsandtherebybreakingthe‘diabolicloop’betweensovereignandbankcreditworthiness.

(ii) Providingthemarketwiththeincentivetocreatea“safe”euroareasyntheticbondtherebyproducinganaturaltargetforEuropeanCentralBankoperationsinthecontextofquantitativeeasing.

TheproposalalsobuildsonideasputforwardbyBrunnermeieretal.(2011)andGaricanoandReichlin(2014)4.Inthepresentreportwegointomoredetailsonhowthetwoobjectivescanbeachievedinpracticeandweintroduceanewkeyfeaturewhichexplicitlylinksattributionsoftherisk-weightedassetsframeworktothedebtrestructuringrulesproposedinChapter1.

The”diabolic”sovereign-bankloop

Thesovereign-bankloophasbeenwidelyrecognizedasanimportantfactorcontributingtothefinancialinstabilityoftheeuroarea.Theviciousdynamicsiswell-known:whensovereignsareintrouble,soarethebanks,astheirgovernmentdebtholdingslosevalueandweighonthebanks’valuations.Conversely,iflargecreditinstitutionshavedifficulties,sovereignscanalsobedraggeddown,asthefiscalcapacityofgovernmentsisdeemedtoosmalltobackstopthebanks,makinginvestorsquestiontheoverallstabilityofthefinancialsystem.

SomeprogresshasbeenmadetobreakthisloopwiththecreationoftheBankingUnionandtheestablishmentofSingleSupervisoryMechanism(SSM)aswellasaSingleResolutionAuthority(SRA).Theroleoftheseinstitutionsistoensureanorderlyresolutionoffailingbanks,withminimumimpactontherealeconomyandonthepublicfinances.

Yet,thereareproblems.Forastart,ajointdepositguarantee,thethirdpillaroftheBankingUniontogetherwiththeSSMandtheSRA,isstillmissing.Furthermore,theResolutionFundisverysmallcomparedtothesizeofthebankingsystemandthestrictapplicationoftheresolutionrules(bailin)seemsproblematicinsomecountries.Forexample,inItaly,theimplicationsofthenewrulesforjuniorandseniordebtholdershadnotbeenmadesufficientlycleartoretailinvestors,causingwidespreaddiscontentwhenlosseswereimposedonsomesaversinDecember2015.Asaresult,theauthoritiesareunwillingtoslashthevalueofinvestmentmadebysmallinvestorsviabailin.Likewise,theapplicationofbailininPortugal

4SeealsoBenassy-Quere(2012)

hasledtocourtcasesanduncertainty.Finally,forthebanksofsomecountries,thehomebiasinsovereigndebtholdingsisstillsubstantial.

Therehavebeensomeimportantstepsforward.Forexample,theEuropeanStabilityMechanism(ESM)canfinancetherecapitalisationoffinancialinstitutionsbyissuingloanstothegovernmentsofmemberstates.However,thataddstothedebtburdenofthesovereignandreinforcesconcernsoverthesizeofthelegacydebtfromthecrisis.TheESMcanalsoinprincipledirectlyrecapitalisefinancialinstitutions-amoreeffectivecircuit-breaker.Butthisispoliticallytoxicandisreallyconstruedasaninstrumentoflastresort.

Apersistentandlargeexposureofbankstothedomesticsovereign

AsshowninFigure1,banks’homebiasintheirholdingsofsovereigndebtincreasedduringthecrisisandthenstabilized.However,forcountriessuchasPortugal,SpainandItaly,theexposureofthebankingsystemtotheirowngovernmentdebtisstillhigh.ForbothItalyandSpain,domesticholdingsofsovereignbondsbymonetaryandfinancialinstitutionsamounttoabout10%oftheirtotalassets.Thismeansthat,inaconservativecasewherebankleverageisequalto10,a50%lossonsovereigndebtwouldwipeouthalfoftheequityofthebanks.

Figure2:StrongHomebiasinmostcountries.Source:ECB.

ThepreferenceofeurozonebanksforsovereigndebtmayhavebeenlinkedtotheirneedtoincreaseretainedearningstobuildorrebuildtheircapitalbaseandgraduallymeetthenewBaselIIIrequirements.Investinginhigh-yieldingperipheralsovereigndebt,whilerefinancingcheaplythankstotheEuropeanCentralBank’slowrateswasconsidered“thegreatestcarrytradeever”(AcharyaandSteffen(2015)).

Butbanksdidnotinvestinjustanysovereignbondsoftheperiphery.Theymostlyinvestedinthebondsoftheirownsovereign.ThiscanbeseeninFigure2,where-exceptforIrelandandtheNetherlands(twosmallopeneconomies)-allcountrieshaveasovereigndebtportfoliostronglytiltedtowardsdomesticdebtholdings.

Wecanthinkofseveralexplanationsforthishomebias.Thefirstismoralsuasionbydomesticauthorities(seeforexampleBeckerandIvashina(2014)).Thesecondisthatbanksmaybe(orhavebeen)bettingonapreferentialtreatmentbythedomesticauthoritiesincaseofapartialsovereigndefault.Thethirdistherealizationthatinthecaseofalargesovereigncrisis,theirownfateiscloselylinkedtotheoneofthesovereignanyway,sothatthereislessreasontodiversifyrisk.Thefourthisthattheriskofadisintegrationoftheeuroareaisstillverymuchpresent:banksthereforestrivetomatchthecurrencyoftheirassetsandliabilitiesincasecountriesweretoreturntotheirnationalcurrencies.Forexample,Battistinietal.(2013)havepersuasivelyarguedthatmarketsegmentationisareactionofthebankstothesharpincrease

0102030405060708090

100

Domestic/EAgov.debtholdings(MFIex.ESCB,%)

Jan-99 Jan-08 Jan-12 Jan-14 Jan-16

insystemicrisk.5Thislastexplanationiscomfortedbythefactthatinsurancecompaniesandmutualfundsalsoexhibitsomehomebias(seeKoijen,Kulischer,NguyenandYogo(2016)).Whicheverthetrueexplanation,theoutcomeisthesame:thedegreeofhomebiastendstoincreasewhenriskgoesup(Reichlin(2014)andColangeloetal.(2016)).

Whenlookingatdisaggregatedbankdata(seeFigure3),thebank-sovereignloopproblemseems,ifanything,moreacute.Asmallbutsignificantnumberofimportantbankshaveexposurestotheirsovereigns(includingbothsecuritiesandloans),whicharewellinexcessof10%oftheirassets.SovereignexposureinFigure3encompassesbothsecuritiesandloans.Theyarelargeandheterogeneousacrossinstitutions.

Figure3:NetSovereignExposureoverTotalAssets

SourceEBAandUCG.

Figure4showstheexposuretosovereignrisk(includingsovereigndebtandloans)asapercentageofbankcapital(ownfunds).Thenumbersareveryhighforanumberofkeybanks,inparticularoftheperiphery.Itseemscleartousthatthereisahighriskofbanksandsovereignsenteringadangerousdynamic.

Figure4:Homecountrynetsovereignexposureovercapital(ownfunds),%.

5Specifically,theyfindthatbanksinperipheralcountriesrespondtoanincreaseinown-countryriskpremiabyraisingtheirdomesticexposure,whileincorecountriestheydonot;andthatallbanks'homebiasincreasesasaresultofanincreaseinsystemicrisk.Theyconcludethatforperipheralcountries,thiscanbeexplainedinpartbycarrytrade,butthatsomethinglikehedgingredenominationriskmustbeplayingarolethroughouttheeuroarea.

20%18%

15% 15% 13% 12%10% 10% 10% 9%

7%6% 5% 5% 5% 5% 4%

Sample Average

Source:EBA,2015andEU-widetransparencyexercise,

MoralhazardandtheECBdilemmaofdoing“toolittle”or“toomuch”

Thelegacydebtissueandthesovereign-bankloop,takentogether,placeanexcessivelylargeburdenontheECB,makingitmoredifficultforcentralbankerstofulfiltheirmandate.

First,sincehomebiasincreaseswheninvestorsaremoreriskaverseandwhenrisksincrease,financialsegmentationintheeuroareatendstoincreaseintimeofstress.ThisimpairssignificantlythefunctioningofmonetarypolicyandmakestherealizationoftheECB’sinflation–thatistokeepinflationcloseto,butbelow2%–verydifficult.

Second,inaworldofvolatilefinancialmarketsandunstableriskpremia,ahighlegacydebtisacauseoffinancialfragilityandsegmentation.ThisputsaheavyburdenontheECB,sinceithastomonitormarketconditionscontinuouslyandinterveneoccasionallyinordertosafeguardthemonetarytransmissionchannel.TheroleoftheECBinstabilisingthesystemhasbecomeparamount.ThiswasmadeclearbytheJuly2012interventionofPresidentMarioDraghiwhenhestatedtheECBwoulddo“whateverittakes”tosavethemonetaryunion,contributingtoasharpreductioninriskpremiaonsovereignbonds.

305

221197

126 123 119 116 113 112 9775 72

53 50 50 48 43 41 34 27 26 21 17 11 4

25%

Whenthereareshockstotheriskpremium,thedebtburdenofsovereignsrisesandmaypreventthemfromstabilizingtheirdebt-to-GDPratios.Insomecases,reducingthestockofnationaldebtwhileservingsoaringinterestrateswouldrequireunattainableprimarysurplusesequaltoseveralpercentagepointsofGDP.Seeingthis,marketparticipantsmightrequireanevenhigherriskpremium,whichfurthertightensmonetaryconditions.TheECBthenhastocounteractthisdestabilizingprocessbylooseningmonetarypolicyandcoordinatingmarketparticipantsonthestablelowinterestrateequilibriumthathelpstomakethedebtservicemanageable.Butthishasnotbeenuncontroversialandseveralpolicymakershavehighlightedthemoralhazardconsequencesofthispolicystance.

Itisimportanttorealizehoweverthatadverseshockstoriskpremiamaynotbenecessarilyhavedomesticreasons,buthavetheiroriginsabroadandreflectglobaleconomicconditionsandriskaversionofinternationalinvestors(GlobalFinancialCycle,seeRey(2015)).Becauseoftheexistenceofself-fulfillingdebtcrises,thelinesbetweensolvencyandliquidityproblemsarecontinuouslyblurredandareendogenoustomonetarypolicy.Indeed,theexperienceoftheeuroareadebtcrisishasshownthattheriskassessmentofmarketshasgonefromextremeparanoiatoexcessivetranquillity.Thisseverevolatilitymaybepartlyexplainedbytheuncertaingovernanceoftheeurozone:Marketseitherbelieveinthestrongcommitmentofthecentralbanktobackstopindividualsovereigns,inwhichcasecreditriskisloweverywhere;ortheydoubtthecommitmenttomonetaryunion.Thiscancauseaflighttosafetythatgeneratesriskpremiasolargethattheyareplausibleonlyunder(possiblyself-fulfilling)expectationsofcurrencyredenominationwithabreakupoftheeuroarea.Ineithercase,butespeciallyinthesecondone,marketsignalsappearunabletoprovidearealisticassessmentofthefundamentalsofeachcountry’sfiscalpositionandthusfailtodisciplineadequatelygovernmentpolicies.

Inalljurisdictions,thelenderoflastresortfunctionofthecentralbankisanessentialpillaroffinancialstability.Intheeuroarea,however,thismustbeexercisedinacontextinwhichthereisnotransparentframeworkforcountriestodefaultandinwhichnationaldebt,evenwhendenominatedineuro,remainsnational.Thisiswhyweneedchangestotheregulatoryframeworkandtoeconomicgovernancethat(a)makeitpossibleforacountrytodefaultwithintheeurozoneaccordingtoruleswhichareclearex-ante(seechapter1ofthisreport)and(b)recogniseriskingovernmentbonds,but(c)provideadiversificationincentivetoavoidmarketsegmentation,inparticularwhenfinancialmarketsarevolatile.Thekeyfeatureofourproposalisthattherulesforachieving(a),(b)and(c)arecoherent.

Principlesforregulationofsovereignholdingsbybanks

Thecurrentregulatorytreatmentofgovernmentbondsforthepurposeofbothcapitalchargesandcollateralconsidersallsovereignbondsessentiallyriskless,independentlyofthelevelofpublicindebtednessofthecountryofreference.Thisframeworkintroducesmoralhazardanddoesnotreflectacountry’sfundamentalrisk.

Whenregulatingthebanks’holdingsofsovereigndebt,thefollowingprinciplesshouldbetakenintoaccount:

• Limitsystemicrisk.Thisimpliesreducingtheincentivestoaccumulateexcessholdingsofsovereigndebt,andinparticular,domesticsovereigndebt.

• Limit transition costs and asymmetric effects across countries. This implies preservingfinancialstabilityduringthetransitionperiodwhenportfoliosarereshuffled.

• Ensure consistencywithotherBaselprudential regulation such the LiquidityCoverageRatio(LCR)orNetStableFundingRatio(NSFR).

• Ensureconsistencywithregulationofotherfinancial intermediariessuchasprudentialregulationofinsurancecompaniestoavoidregulatoryarbitrage.

• Avoidimposingregulationswhicharepro-cyclical.• Ensureconsistencywiththeobjectivesofmonetarypolicyandfinancialintegration.• Promotetheuseofasafeasset,whichwillavoidfuturedestabilizingportfolioshifts.

Thereareseveraloptionswhichcanbeenactedtoachievesomeoftheseobjectives.Wereviewthembrieflyandthenputforwardourpreferredproposal.

1) Imposelimitsonbanks’exposuretoallsovereigns.Forexample,regulatorscouldlifttheexemptionofsovereignbondsto the limitedexposureruleanddecidethatbankscanholdnomorethan,say25%oftheircoreTier1capitalinsovereigndebt.Ifenacted,thisproposalwouldhaveseveraldrawbacks:firstly,itwouldgivebanksanincentivetoloadupontheriskiestsovereigndebt,inordertoincreaseprofitability.Secondly,itwoulddonothingtopromotethecreationofasafeasset.Thirdlyandmostimportantly,itcouldcauselargeportfolioshiftsduringthetransitionperiodandanimmediateshocktoassetprices.Manybanks,especiallyintheperiphery,wouldneedtodownsizemassivelytheirholdingsofdomesticsovereigndebt.Whilewehavenopreciseestimatestodatefortheabsorptioncapacityofthenon-banksectorforadditionalsovereigndebtholdings, it islikelythatthiswouldbelimitedandthattheensuingpriceeffectswouldbehigh.Thissuddenshiftisriskyinanenvironmentofhighlegacydebt.Imposingthislimitonbankexposurewithalongtransitionperiodcouldsomewhatmitigatethisproblem.However,since asset prices are forward looking, some price adjustmentwould take place rightaway.AnotherwaytolimitthisshiftwouldbeviaassetpurchasesbytheEuropeanCentralBank,thoughquantitiescouldbeverylarge,placinganexcessiveburdenontheECB.

2) Impose risk weights on sovereign debt. The weights could be decided by the creditratings agencies and based on market measures such as CDS prices or on economicfundamentals.Thisproposalalsohasseveraldrawbacks.First,itintroducesanelementofprocyclicality,sincebankscouldbeforcedtosellsomesovereignbondsatatimeof

stress.Thismayamplifysovereigndistressespeciallyiftheweightsarebasedonmarketindicators.Second, justas the firstproposal, itmay lead tosubstantialportfolio shiftsduringthetransition.Conversely,thisproposalhastheadvantageofmakingbanksmoresolidbyincreasingtheirloss-absorptioncapacity.

3) Imposeriskdiversification.Regulatorscoulddecidethatbasketsofeuroareabonds -weighted by GDP or by ECB capital share - should carry a zero risk weight. Thesediversified securities would be tranched in senior and junior debt. Meanwhile,governments would not be jointly liable for these securities. The advantage of thisproposal is to create a safe asset (the senior tranche) that would be geographicallydiversified.Bycombiningtranchingwithdiversification,thisframeworkexpandsthefiscalcapacity that backs the safe asset and provides robustness to swings in perceivedcreditworthinessduringepisodesofflighttosafety(seeBrunnermeieretal,2011fortheoriginal proposal, and Brunnermeier et al, 2016, for why both tranching anddiversification are necessary). This safe asset could also be used in monetary policyoperations of the ECB (see Garicano and Reichlin, 2014). It would be parallel to USTreasurieswhosevastandliquidmarketsenabletheUStofunditselfat lowcostsandprovideinsurancetotherestoftheworldduringperiodsofglobalmarketturmoil(seeGourinchas,ReyandGovillot(2010)).Thedisadvantageofthisproposalisthatitwouldreduceriskpremiaandlimitmarketdiscipline.

Ourproposal isahybridofpromotingdiversification (withcreationofa safeasset) (3)andimposingriskweights(2).IthastheadditionaladvantageofbeingconsistentwithoursteadystateregimeofsovereigndebtrestructuringdescribedinChapter1.

Before outlining in detail themechanics of our scheme, we first provide its general guidingprinciples:

• First, we propose that the ESM/ECB assign risk weights to each eurozone country’ssovereigndebt.Theseweightsshouldbecomputedfromthemarginalbandsbasedonthe Debt Sustainability Exercise described in Chapter 1 and then aggregated into anaverageriskweightforeachcountry.Asaresult,theriskinessofasovereignbondwouldbeconsistentwiththefiscalpositionofitsgovernment,asassessedandmonitoredbytheESM,withinoursteadystatefiscalframework.

• Second,weproposethattheESM/ECBintroducearegistrationschemetoencouragetheprivatesectortocreatesovereign-debt-backedCDOs.Underthescheme,CDOsbackedbyqualifyingportfoliosofsovereignbondscouldbedividedintotranches.Thetrancheswould thenbe registered, andeachwould thereby attract a differentquantity of riskweighted assets (RWAs). To qualify, the underlying portfolio would have to contain

sovereignbondsfromthedifferenteuroareasovereignsinproportiontotheirsharesofeuroareagrossdomesticproduct (orECBcapitalkeys),withinsomeexplicit tolerancebands.TherulewherebydifferenttrancheswouldattractdifferentRWAswouldensurethat in aggregate these tranches attracted the sameRWAs as if thebondswerehelddirectlybyabank.At thesametimetherulewouldallowonetranchetoattractzeroRWAswhiletheothersattractedmore.Inaddition,theregistrationschemewouldrequirethatthetranchesbegivendifferentialseniority,sothatthetrancheattractingzeroRWAswasalsoseniortotheothertranches.Thesemeasurescombinedwouldencouragethecreationofasetofsecurities(“SeriesA”oftheregisteredCDOs)whichwouldbeabletoplaytheroleofaeuroareasafeasset.

Thisproposalhasseveraladvantages.First, theriskweightswillensurethateachbankbuildssomeriskabsorptioncapacitywhenexposedtosovereignrisk.Secondly,thereisdifferentiationofcreditriskacrosscountriesandmarketdisciplineismoreeasilyenforced.

Meanwhile, this scheme helps deal with the transition problem and stabilize debt prices asportfolioshiftsare lesspronouncedbecauseofthegeographicaldiversificationprinciple. WecouldevenavoidanypriceeffectsbyorganizingswapsofnationaldebtagainstGDP-weightedbasketsofbondsbetweentheECBandthebankingsector.Forexample,anItalianbankcouldswapItaliansovereignbondsagainstanequivalentamountofdiversifiedsovereignbonds(atthemarketprice)heldonthebalancesheetoftheECB.Giventhecurrent,expandedbalancesheetoftheECB,thisswapoperationcouldabsorbalargeamountofnecessaryportfoliorebalancingwithoutanypriceeffectandwithoutchangingtheportfoliooftheECB.NotethattheriskprofileoftheECBwouldnotchange:thecentralbankreceivesinflowsfromSpain,Germany,Italy,andrepackagesittoreturntheportfolio.Giventheirlargeinventory,theycanswapitrightaway.So,ineffect,theECBwouldbetheintermediaryoftheswapofdebtbetweennationaldebtsandthediversifiedbonds.

ThisschemealsohelpstheECBmeetitsobjectiveofpricestabilityasitpreventssegmentationfromimpairingthechannelsofmonetarypolicyinstressedtimes.Finally,thisproposalcreatesaeuroareasafeassetwithmostofthedesirablepropertiesoftheUSTreasuryBonds.

Thereare,however,somelimitations:(a)itwilltakesometimetobuildupsufficientquantityofthesesecuritiesinthemarkettomatchtheliquidityofthemarketforTreasurybonds,and(b)whileprotectedbytheirseniorstatus,theseCDOs,unlikeTreasurybonds,arestillbackedbytheseveral,notjoint,obligationsoftheeuroareasovereigns.

Detailedmechanics

§ Step1: Assigndifferent riskweights to the sovereigndebt of eacheurozonememberstate.ThisisdonebylettingtheESMconductitsDebtAssessmentexerciseasdescribed

inChapter1,usingaseriesofmarginalbands.Forthesakeofsimplicity,wewillchooserisk weights using debt-to-GDP thresholds. In practice, these thresholds might bedeterminedbytheESMusinganumberofcriteria,includinggrossfinancingneeds,andmaynotcoincideexactlywiththesenumbers

• <60%:zeroRWA(Tier1)

• 60-90%:x%RWA(Tier2)

• >90%:y%RWA(Tier3)

Figure5showsanexamplewheretheDSAweightsarebasedpurelyondebt-to-GDPratios.

Figure5:EAmembers’publicdebt/GDP(%)

0" 30" 60" 90" 120" 150" 180"

Austria"

Belgium"

Cyprus"

Estonia"

Finland"

France"

Germany"

Greece"

Ireland"

Italy"

Latvia"

Lithuania"

Luxembourg"

Malta"

Netherlands"

Portugal"

Slovakia"

Slovenia"

Spain"

Tier"1:"0M60%"debt/GDP" Tier"2:"60M90%"debt/GDP" Tier"3:">90%"debt/GDP"

Thedifferentcolourscorrespondtothedifferent%RWAs.Thewholeofacountry’spublicdebtattracts the same% RWA, calculated as theweighted average of the different risk weights,dependingonhowmuchdebtisineachofthethreebands.Thetablebelowshowsanexampleofhowhightheriskweightswouldbeifoneused0,10%and20%,respectively,forTier1,2and3debt.

§ Step 2:Allowqualifying collateraliseddebt obligations (CDOs) backedby portfolios ofeurozone sovereign bonds to be registeredwith the European Central Bank/Bank forInternationalSettlementsandtherebyqualifydifferenttranchesfordifferentRWAs

• Toqualify,aCDOmustbebackedbyaportfolioofsovereignbondsheldincertainproportions(e.g.,%ofeurozonegrossdomesticproduct,orECBkeys)

• Differenttranches(e.g.,seriesA,B&C),aregivendifferentseniorityandeacharedesignatedtoattractdifferentRWAsaccordingtothecompositionofthewholeportfolio.

Afewmorepointsonthemechanics

• CDOscanbeconstructednotonlyfromnewissuesbutalsofrombondspurchasedinthesecondarymarket.

• Inoursteadystatefiscalframework,whendebtrestructuringhappensinonecountryitwill be important toensure thatwenever cut thedebt-to-GDP ratiobelow60%.ThismeansthatthedebtrestructuringexercisemayaffecttranchesBandCoftheCDO,butwillneveraffecttrancheA,validatingitsstatusas“safe”asset.

• ItwouldalsobeimportanttopreventanysovereignfromissuingnewdebtwithastatusseniortothatofthebondsbackingthequalifyingCDOs.

• The governance structure of the ESM is key and should guarantee competence,independence and accountability. The risk weights based on the assessment of thefundamentalsinthedebtsustainabilityanalysisarekeydeterminantsoffinancialstabilityandmarketincentives.

• Therulegoverning“qualifying”CDOswouldalsorestrictthematuritiesofthebondsinthe underlying portfolio, so as to ensure a consistent maturity structure across the

portfolio.Forexample,atypicalqualifyingCDOmightbeissuedbackedonlybyliquid10yearbondsatthetimeoftheCDO’sissue.

• Atthelimit,theconstructionofqualifyingCDOswouldberestrictedbytheavailabilityofeachmemberstate’ssovereignbonds.However,anappropriateruleforthetolerancewithinwhichtheportfolioconstructionwouldhavetoreflectsharesofEAGDPshouldmeanthatthisthresholdisquitehigh.Itiseasytodefineasetofrulesthatallowforthecreationofupto€100billionofsuchsecurities,forexample.TheseruleswillneedtobevalidatedbytheESM/ECB.

Summaryoftheadvantagesofourproposal

Ourhybrid approachoffers several advantages. It ensures that there is some risk absorptioncapacity forsovereignswhilestillallowingthemarkettoenforcediscipline. Itencouragesthecreationofalargesafeassetmarket(CDOseriesA)carryingzeroriskweight,whichisvaluablefor financial institutions and for the ECB’s conduct ofmonetary policy. It alsominimizes thedisruptionscausedbythetransitiontoanewsteadystateandavoidsdamagingportfolioshiftslinkedtogeographicflighttoquality.WecouldevenavoidanypriceeffectsbyorganizingswapsofnationaldebtversusGDP-weightedbasketofbondsbetweentheECBandthebankingsector.

It is also consistentwith our long-run fiscal framework and ensures riskweightswithin thatframeworkhaveaneconomicrationaleandprovidebanksandsovereignstherightincentives.Furthermore,thewaytheriskweightsareconstructedavoidstheexcessiveprocyclicalitythatmarketmeasuressuchasCDSspreadswouldcause.Itcanbeimplementedcentrally–bysettingRWAsandCDOregistrationrules–withouttheneedtoinvolveeachsovereignissuerdirectly.Finally,ourframeworkseversthesovereigndebtloopandhelpstheECBfulfillitspricestabilitymandate.

Chapter3:Managingthetransition:thequidproquo

Giventhestatusquoofhighdebt,wecannotsimplyre-modelourexistingfiscalandregulatoryinstitutionsasdescribedinChapters1and2.Thiswouldbedangerous,asthetransitionpathwouldbehighlydestabilizing.Imagine,forexample,announcingtheimplementationofthedebtrestructuringmechanismdescribedinChapter1inanenvironmentwhereseveralcountriesarealreadyhighlyindebted.Theresultcouldbearunontheirdebt.

Managingthetransitiontowardsbetterinstitutionsisessentialandthestartingpointcannotbeignored.Thewaytodealwiththetransitionpathproblemisaquidproquo:weproposeacoordinatedone–offsolutiontodecreasethelegacydebtinexchangeforapermanentchangeininstitutions.ThispermanentchangeininstitutionsistheadoptionofthefiscalframeworkdescribedinChapter1andoftheaccompanyingbankingregulationframeworkdescribedinChapter2.Themostobviousalternativeapproach–lettingtheECBholdgovernmentdebtboughtviaquantitativeeasingindefinitely–wouldendupplacinganexcessiveburdenontheCentralBankandwouldletthesituationdragonfordecades.

Conversely,ourapproachreducestheriskofmoralhazardlinkedtothecoordinatedeliminationofthelegacydebt.Everycountryendsupinabetterplace.

Dealingwiththelegacydebt:aone-timedebtstockoperation

Inthischapter,wearticulatestrategiestoimplementaone-timedebtstockoperationaimedateliminatingthepublicdebtoverhanginallparticipatingcountriesatthesametime.TheultimategoalistoboostgrowthintheEurozonebyeliminatingtheoverhang–thusincreasingtheincentivestoinvestanddecreasingtheuncertaintyduetopossibleself-fulfillingrunsinhighlyindebtedcountries–inasustainablemannerbyimprovingthelong-runfiscalandfinancialframeworkoftheEuroarea.Thisisthequidproquo.

Wepresentamenuofpossibilitiesforthedebtreductionoperation:(i)adebtbuybackviaaStabilityFundthatusescapitalizedrevenuesfromeither(a)taxes(wealthtax,VAT,carbontax,etc…)or(b)seigniorage;and(ii)aswapoperationthroughwhichsovereignbondsareexchangedagainstacombinationofdebtandequity(GDP-indexeddebt).Sinceeachoptionhascostsassociatedtoitandthescaleofthedebtreductionneededislarge(weaimatbringingeachcountrytobelowthe90%debt-to-GDPratio),thebestcourseofactionwouldbetoimplementacombinationoftheseoptions.

Furthermore,itispossibletoperformthedebtbuybackusingonlynationalresourcesbutitis

moreefficienttoallowlimitedandtemporaryrisk-sharingacrosscountries.Theusualmoralhazardissuesassociatedwithcross-countryrisk-sharingaredealtwithviatheimplementationofthenewgovernanceframeworkdescribedinthepreviouschaptersandwithinwhichthe“nobailoutclause”canbecrediblyenforced.Atthesametime,switchingtothenewsteady-stateframeworkismadepossibleonlybecauseofthereductionindebtlevels.Inwhatfollows,wepresentthedifferentoptionsforretiringdebtandhowtheycouldbeimplemented,andwegivesomeideasabouttheircalibration.Formoredetails,interestedreadersshouldrefertoMEZ1.

TheStabilityFund

TheStabilityFund,establishedforexampleundertheauspicesoftheESM,willbuybackasignificantportionofcountries’debt(tobringtheirdebttoGDPratiosbelow90%)andretireit.ItwillfinanceitspurchasesandinterestcostsbyissuingStabilityFunddebt,withaboutthesamematurityasthebondspurchased,collateralizedbycapitalizedfuturefiscalpaymentsoftheparticipatingcountries.EachTreasurywillcrediblycommittodedicatesomefiscalrevenues(someofwhichcanbenewfiscalsources)foraperiodoftimetotheStabilityFund.TheStabilityFundwillbeguaranteedbythesovereignsoftheeuroareaparticipatingintheoperation.TheStabilityFunddebtwillbeoffthebalancesheetofthesovereigns.StabilityFunddebtwillbeacceptedbytheECBastop-qualitycollateralforrefinancingpurposes.Theoperationboilsdownthereforetoswappingnationaldebts,subjecttodefaultriskintoanominallysafeassetissuedbytheStabilityFund.

CountrieswillcommittopaysomefiscalincomeintotheStabilityFundforanextendedperiod(say50years).Inordertomakesurethispromiseiscredible,onecouldforexampleuserevenuestreamswhicharegeneratedattheeuroarealevelsuchasseigniorage.ThosecouldbepaidstraightintotheStabilityFund6.Onecouldalsousesomeextrataxrevenueswhichcouldbegeneratedviawealthtaxes,forexampleonsecondhomes,payableoveranumberofyears(someofthehighlyindebtedcountrieshavehighwealth)orviaacarbontax.AnotherpossibilityistousesomeextrapointsofVATforanumberofyears.SomeVATrevenuesalreadyfindtheirwayintotheEuropeanbudget.Incasepaymentsfallshort,thelengthofthepayment6Thepreciselegalmodalitiesofsuchanarrangementwouldhavetobeworkedout.ForanearlyproponentoftheuseofseigniorageseeBuiterandRahbari(2012)andParisandWyplosz(2014).SeealsoMEZ1.Onecouldalsoimplementprogressivebuyoutschemes(insteadofretiringallthedebtdownto90%inashorttimeframe).OnecouldforexamplekeepsomeofthenationaldebtonthebooksoftheStabilityFund(withnointerestpaymentsfromthesovereignsaslongaspaymentsintotheFundaremade)andretireitonlyprogressivelyasthecountrieshonourtheirobligationvis-a-vistheFund.Otherwiseitcouldbeputbackintothemarkets.

periodcouldbeincreased.UltimatelythesolvencyoftheStabilityFundisguaranteedjointlybyalltheTreasuriesbutthisistrueduringthepaymentperiodonly,sothereisonlytemporaryandverylimitedrisksharing.TheliquidityoftheFundisguaranteedbytheECB.

Example:onesimplecalibration.

Assumeeachcountryoftheeuroareacommits0.5%ofitsGDPeachyeartotheStabilityFundfor50years.Undertheconservativeassumptionsofanaveragerealinterestrateof2%andofanaveragerealgrowthrateof1%,thenetpresentvalueof0.5%ofGDPcommittedforthenext50yearswouldbeabout2000bneuros.Assumefurtherthatabout1000bnoffutureseigniorageoftheECBiscommitted7.TheStabilityFundsecuritizesthese3000bneurosandusesthemtobuybackthedebt.

Withoutanyredistribution,i.e.usingonlythenetpresentvalueofthenationalresourcesdescribedabove,thenewdebtlevelswouldbethefollowing(seeTable3.1)

Table3.1 Newdebtlevels 2015debtlevelsBelgium 78.3% 106.7%Germany 43.1% 71.4%Estonia -22.9% 10.0%Ireland 71.9% 99.8%Greece 158.3% 194.8%Spain 69.3% 100.8%France 67.4% 96.5%Italy 102.5% 133.0%

Cyprus 74.5% 106.7%Latvia 2.1% 38.3%

Luxembourg -3.3% 22.3%Malta 35.2% 65.9%

Netherlands 40.4% 68.6%Austria 58.5% 86.6%Portugal 94.5% 128.2%Slovenia 51.6% 84.2%Slovakia 18.8% 52.7%Finland 34.1% 62.5%Lithuania 7.1% 42.9%

Source:AMECO2015andauthors’calculations

AscanbeseenfromtheTable,theschemeleadstosizablenationaldebtreductionsbutItalyisstillaboveourtargetof90%debttoGDPratio(soisGreece,butGreeceisaspecificcase

7Theamountof1000bnofseignioragefortheECBona50yearperiodisveryconservative.FormuchlargerestimatesseeBuiterandRahbari(2012)andParisandWyplosz(2014).

andthedebtburdenofGreeceshouldbedealtwithseparately).

Smallamountoftemporaryrisksharing

Wecouldalsoallowforasmallamountofrisk-sharing.Forexample,theStabilityFundcoulddistributeitsrevenuesinequalsharetoeachcitizenintheeuroarea(resourcesdividedbycountriesinproportiontothepopulation).

Inourindicativeexample,eachcitizenwouldbe“given”adividendofabout9000euros,i.e.,eachcountrywouldbegivenashareoftheStabilityFundresourcesinproportiontoitspopulation.InthatcasethenewdebtlevelsineachcountryafterthebuybackwouldbethoseshowninthefollowingTable3.2.ThetransfersineurospercitizenandperyearonafiftyyearhorizonarepresentedinthesecondcolumnoftheTable.NotethatwedidnotincludeintheschemetheBalticsandSlovakiaastheschemewouldleadthemtohavenegativedebt(theyhavelowdebttoGDPratiostostartwith).SomeincentivescouldbegiventothosecountriestoneverthelessjointhesteadystategovernanceframeworkdescribedinChapters1and2.

Table3.2 NewdebtlevelsTransferspercitizenperyear(ineuros)

Belgium 81.5% -24Germany 46.3% -23Estonia 10.0% 0Ireland 79.1% -63Greece 137.5% 66Spain 61.6% 36France 68.6% -8Italy 99.0% 19Cyprus 61.9% 52Latvia 38.3% 0Luxembourg 12.0% -270Malta 19.6% 62Netherlands 45.9% -44Austria 63.2% -37Portugal 75.4% 66Slovenia 35.2% 61Slovakia 52.7% 0Finland 38.5% -33Lithuania 42.9% 0

Source:AMECO2015andauthors’calculations

Inthisscheme,thelargestnetcontributorwouldbeLuxembourgwhowouldgiveout270eurospercitizenandperyearforfiftyyears.ThelargestrecipientswouldbeGreeceandPortugal(66euroseachpercitizenandperyear).ForallthecountriesexceptGreeceandItalythisschemewouldbeenoughtobringthedebttoGDPratiobelow90%.AsmentionedaboveGreeceisaspecificcase.ForItalyotherfiscalrevenuesshouldbeadded.Onepossibilityistouseorincreasethewealthtaxforexampleonsecondhomes,whichcouldbeleviedduringthesame50yearperiodoranyperioddeemedappropriate.Anotherpossibilityistousedebtequityswaps(alongthelinesofMEZ1).

Isthisschemeworthit?

Advantagesofthisschemearethefollowing:

- Itcanbedonequickly.

- Itwouldnotthreatenfinancialstabilityasitwouldboostthevaluesoftheassets(indeeditshouldbedesignedtoavoidwindfallsforinvestors)

- Implementingtheschemeinthecurrentenvironmentofhighdebtvaluationsduetoquantitativeeasingmeansthattheissueofthemarketvalueoftheremainingdebtincreasingsignificantlyafterthebuybackislikelynottobeaconcern(seeBulowandRogoff(1998)).Tomakesurewindfallsremainlimited,debtcouldbeboughtclosetomaturity.

Issues:

- Itinvolvescommittingfuturerevenuesinacredibleway.Asdiscussedaboveonecanthinkofseveralmechanismstoincreasecredibility.Onecoulduseeuroarearesources(seigniorage)ordoaprogressivebuy-back.

- Inourpreferredscheme,thebuy-backinvolvesgeneratingextrataxrevenues(forexampleusingwealthtaxes),butthisincreasecanbespreadoutonalongperiodoftimeinordernottohurteconomicactivityintheshortrun8.

- Inordertomoreeffectivelyreducedebt,someamountoftemporaryrisk-sharingwouldbenecessary.Thisdoesnotneedtobedonefortheschemetowork,butitwouldbemoreeffective.

8 SuricoandTrezzi(2015)showsthattheeffectofataxonsecondaryhomesisveryminorforaggregatedemand.

Whythedebtbuybackoperationisnotanaccountinggimmick

Thedebtbuy-backisnotaneutralfiscaloperation.EveninthecasewherethebuybackisdoneusingonlynationalresourcesandwithoutgeneratinganyadditionaltaxrevenuesitisnotneutralasitinvolvesswappingnationaldebtwithdefaultriskforanominallysafebondissuedbytheStabilityFund.Italsoinvolvescommittingtoanewfiscalframework.

Inaddition,inourpreferredschemewithsometemporaryrisksharingandsomeextrataxrevenues,itisevenmoreobviousthatthebuy-backisnotaneutralfiscaloperation.

TheStabilityFunddebtisoffthenationalbalancesheetsforthesteadystatefiscalgovernanceframeworkoutlinedinChapter1whichreliesinparticularondebttoGDPratios.ItcarrieszeroriskweightsinthebankingregulationframeworkoutlinedinChapter2.

Chapter4:Refugeebonds

TherecentwaveofimmigrantrefugeestoEuropeposesgreatchallengestotheEuropeanUnion.Whilethemostimportantofthesearelikelyinthepolitical,humanitarian,andsecurityfronts,economicscanplayasmallbutnon-negligibleroleinhelpingtodealwiththiscrisis.Inthischapter,weproposeasimplefinancialinstrument,“EUrefugeebonds”,whichprovideamodestcontributiontohelpdealwiththerefugeecrisis,whilepossessinginterestingpropertiesthatcansupplementtheconstructionofanewfinancialarchitectureinEurope.

Thechapterisstructuredasfollows.First,wearguethattheintegrationofrefugeesandthesecuringofthe borders are European public goods,which therefore require a European-wide policy in response.Second,wediscusshowthesegoodscanbepartiallyaccomplishedbyraisingexpendituresinafewsocialprograms.Third,sincetheinitialexpenditurerequiredtosetuptheseprogrammesismostlyupfrontandgeographically concentrated, while their benefits materialize over time and may be geographicallydispersedintheEU,wearguethattheirimplementationshouldbefinancedviaacommonbondissuanceratherthancurrenttaxesor largespendingcuts, ifonlytemporary,tootherchaptersofspending inaspecificregionoftheunion.Forthisreason,weproposeatypeoffinancial instrument,anEUrefugeebond, to finance these expenditures and discuss how they would be integratedwith the rest of theEuropean financial architecture. We conclude discussing some potentially broader impacts of thesebonds.

RespondingtotherefugeecrisisasaEuropeanpublicgood

WithintheSchengenarea,refugeescanmoveeasilyandquickly.Infact,partofthecrisishasbeendriven by how quickly the refugees entering mostly through Greece, have moved and especiallyconcentratedinsomeareasofEurope.Atfirst,therefugeecrisisputsparticularpressureonthebordercountries,whichhavetoreceiveandprocesstheimmigrantswhilesecuringEuropeanborders.Becausebytheirnaturethesemigratoryflowsarequitemobile,refugeescanhoweverquicklymoveacrossEuropeandrespondstronglytorelocationincentives,intermsofbothlocaleconomicconditionsaswellaspolicydifferencestowardsrefugeeintegrationorsocialwelfare.Therefore,regardlessoftheoriginalcountryoftherefugees,theirdestinationisEuropeasawholeandtheyarebestperceivedasanaggregateshockwithuncertaindifferentialimpactsondifferentregions.9

Asidefrombeingcommon,theotherpropertyofthisshockisthatitwaspartlyanticipatedanditis likelytopersist.Figure1showstheevolutionofasylumapplicantstoEurope,splitbetweennations,since2008.Whilethereiscertainlyabulgein2014and2015,thenumberofasylumseekershadbeensteadilygrowinginEuropeforalongtime.Lookingfurtherbackintime,therewasalargemigrationtoSpainandItalyfromNorthernAfricaattheturnofthecentury,andlookingevenfurtherbackrefugeeswent from theBalkans to the centreof Europe in theearly 1990s.Refugees arenot anovelty to theEuropeanreality,andtheyarelikelytocontinuecoming.Moreover,thelargecurrentpopulationsintheMiddleEastandNorthAfricamakeiteasytoforecastthat,evenifthecurrentwaveofrefugeeshaltsfor

9SeealsothediscussionabouttherefugeecrisisasaEuropeanprobleminSymposium:HowtoSolveEurope’sMigrationCrisis,Politico,2/8/16,http://www.politico.eu/article/solve-migration-crisis-europe-schengen/.

politicalreasonsandeveniftherefugeesmaybeendupreturningtotheirhomecountries,stilltherewillbeaconstantflowofimmigrantsandasylumseekerstotheEuropeanUnioninthefuture.

Acommonshockthatispartlyanticipatedandpersistentisonethatishardtoinsureagainst(orself-insure)byindividualcountries.Itisthetypeofshockthateconomicprincipleswouldsuggestisbestdealtwithviaacommonpolicyinstead.

Figure1

Source:GermanCouncilofEconomicExperts(2016)

Integrating the refugees in turn leads to costs and benefits that are common, and involvesexternalities across the Union. More fundamentally, the Charter of Fundamental Rights states thatEuropeansmustprovideasylumas abasic right to all. Theprovisionofhuman rights and shelter is acommonvalueofWesternsocieties.Therefugeecrisisisaboveallhumanitarianaidandforeignaffairspolicies,whicharebydefinitionpolicieswithexternalsocialeffects.Alongthesametoken,internalandexternal securityareEuropeanpublicgoodsandso is the freemobilityof labour thatcomeswith theSchengenagreement(seealsodeVriesandHoffmann2016).

Second,thecostsofintegratingrefugeesarefrontloaded,andsofalldisproportionatelyonthehost country. Yet, the benefits of eventually having a well-integrated and productive citizen of theEuropeanUnion accrue in the long-runby the countrywhere the immigrant eventually settles.Moregenerally,ifweacceptthefreemobilityoflabourinEurope,thenthebenefitsareultimatelybornebyall.Moreover,asthere iswidevariety intheextentandcostsof labourmarket integrationpoliciesacrossEuropetogetherwithlargedifferenceinthetaxationoflabour,afreeridingproblemariseswheresomecountrieswouldbearmostofthecostsandothersmightgetmostofthebenefits.10

10ForcostestimationsseeRuist(2016)and,withafocusonGermany,GermanCouncilofEconomicExperts(2015).

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Athirdandfinalexternalitycomesfromthecostsofsecuringtheborderandperformingtheinitialprocessingoftheimmigrants.FollowingtheDublinagreement,arefugeethatenterstheEuropeanUnionmust havehis or her applicationprocessed in the countrywhere heor she first landswithin the EU.Therefore,countriesattheborderfacethebluntofthesecostsandmaytrytopreventtheasylumseekersfromcominginthefirstplace.IfonecountryattheborderoftheEUrefusestoacceptasylumseekers,ortreatsthemharshlyorincompetently,thismaysimplyleadtoadiversionofthemigrationroutestocrossinstead its neighbouring country that is also in the EU. This attempt to shift the costs of processingimmigrantsarrivinginEuropebecomesaclassicfree-riderproblem.

Therecentsurgeofrefugeeshasaclearcauseintheseverepoliticalandhumanitariancrisesinthecountriesoforigin.AconcernincreasinglyvoicedbypolicymakersandpoliticalpartiesacrossEuropeisthattheintensityandpersistenceofthemigratoryflowwillnonethelessbeendogenoustothepoliciesadoptedinthereceivingcountries,andopenthedoortosecuritybreaches.Thequestionisthuswhetheracommonpolicycancoordinatenationalstatesonaconvincingandeffectivestrategytomanagetheshock. This will require sharing strategies and instruments in a consistent way, preserving thehumanitarian and legal goals of the common policies, while policing possible issues in security andmanagingtheaccesstotheprogramme.Giventhesizeoftheshock,andthecross-borderspilloversofacountry’sstandonthisissue,anuncoordinatedapproachatthenationallevelwilllikelybelesseffective(in termsof itspolitical andhumanitariangoals) andefficient (in termsof itseconomic costs), thanacoordinatedapproach.Whilethedesignofacredibleoverallstrategypertainstopolitics,theproposalinthis report provides policymakers with an effective instrument of financing and organizing theimplementationofitsdecision.

Altogether,therefugeecrisispresentsacommonpersistentshockthathastobedealtwithviacommon long-runpolicies,which internalize thecostsandbenefitsacross theEuropeanUnion. It is aprimecandidateforapolicythatshouldbeEuropeanratherthannationalinordertosharetheburdenina solidary way. At the same time, because securing a border or integrating a person requires localknowledgeandaflexibleapproachadaptabletotheplaceandthepeopleinvolved,itisnotnecessarilybest done by a single European entity instead of the national authorities. Reconciling these twocharacteristicsrequiresatleastthatthefinancingofsuchapolicyiscommon,eveniftheimplementationmaybeamixofEuropeanandnationalpolicies.

Theuseoffundsforsecurityandintegration

ThelargeandquickinfluxofrefugeesposestwoseparatechallengestotheEuropeanUnion.Thefirstconcernsthesecurityoftheborders,thesecondtheintegrationofthosethatarrive.Inboth,existingEuropean institutions appear to be understaffed and underfunded (see van den Born et al., 2013,EuropeanCommission2015,Ratzel2016).

Starting with security, under European principles, the European security agencies can onlybecomeactivewhenamemberstateasksforhelp.Thissubsidiarityprinciple impliesthattheycannotproactivelyacttotakepreventivemeasures,suchasprovidinghumanandphysicalresourcesatpointsofentry of large waves of migrants. The main security agency is Europol. It provides coordination andintelligencetonationalsecurityforcesinordertoshareinformationonorganizedcrime.Itwasnotsetuptoaddressthemajorsecurityconcernthatcomeswithwavesofimmigrants,whichisterrorism.Ithasnocoercivepowersanditworksona“needtoknow”ratherthana“needtoshare”basis,sothatwithout

theopennessandcooperationofthenationalauthorities,itcanaccomplishlittle.Figure2plotsitsstaffandbudgetovertime.SincethestartoftheEurocrisis,bothhavebeenflat.Thereisanoticeablecontrastbetweenfigures1and2:theincreaseinasylumseekershadlittledetectableinfluenceonstaffandbudgetofEuropol.

Figure2

Source:Europol(2016)

Turningtointegrationofrefugees,themainEuropeanagencyisFrontexinWarsaw,togetherwiththe European Asylum Support Office (EASO) in Malta that trains asylum officials and coordinatesrelocations,aswellaseu-LISA, inTallinnandStrasbourgtoprovidetechnicalsupporttotheEURODACregulations on collecting information on asylum seekers. These all command no significant operatingresources.MuchlikeEUROPOL,theyservemostlytocoordinateinformationbuttheyhaveverylimitedinterventioncapability. It fallsoneach individual country to receive theasylumseekers that first landinsideitsborders,registerthem,inquireabouttheirskillsandhumancapital,andprovidethemwithfood

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Figure3

Source:Frontex(2016)

Given this status quo, there seems to be large scope for improvement in both security andintegration.Afewsuggestionsthatwouldimprovesecurityare(seevandenBornetal.,2013,EuropeanCommission2015,Ratzel2016):(1)tooperatealegalchangesothattheEuropeanagenciescanbecomeactivewithoutdemandofamemberstateaslongassomenarrowlydefinedconditionsaremet,suchasarefugeecrisis;(2)tointegratecareersanddelegatestafffromthenationalagenciesinordertohavethem better integrated with the European agency; (3) to share information at early stages of

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investigations; (4) tobeabletoengage in fastoperational (butnotcoercive) interventions; (5) togiveEUROPOLalargerbudgetandstaff,andFRONTEXoperationalresourcessoitcouldinterveneinthefield;(6) and, perhaps more ambitiously, to create a common European border and coast guard that caninterveneinemergencysituations.

Atthesametime,inordertoimprovetheintegrationofrefugees,therearemanyneedsforfurtherresources:(1)theprovisionofurgenthumanitarianaidattheborder,(2)toprovidehousing,eitherpublicorprivate,(3)tomaketransferpaymentstotherefugeesinordertoprovidethemaminimumstandardofliving,(4)toprovideforlanguagetraining,educationandintegrationtothenewlegalenvironment,(5)toapplyactivelabourmarketpolicies,likejobtraining.

Alloftheseproposalsbuildonalreadyexistinginfrastructuresandpolicies.Butscalingthemtoalevelthatcanrespondsatisfactorilytothecurrentwaveofrefugeesrequiresexpendituresthatcanpotentiallybelarge.Theyarehardtoestimatesincethescopeofeachofthesepolicies,whichalreadyexisttodayandwould only have to be scaled up, differs widely across countries. Berger and Heinemann (2016)estimatethatafullprovisionofasylumservicesattheEUlevelwouldamountto30billionEurosallowingforsavingsofabout40percentascomparedtonationalprovision.

Refugeebonds

Having established that security and integration of refugees are European public goods thatshouldbefinancedbyallthecountriesintheEuropeanUnion,andhavingestablishedthatadequatelyaddressing the refugee crisis would require a significant amount of extra spending, we come to ourproposal:theissuanceofEUrefugeebonds.11

Whybonds?Becausethecostsoccurnow,securingthebordersandintegratingimmigrants,butthebenefits comewith time,both in termsofpeaceaswell as in termsofnewproductiveEuropeancitizens.Debtfinancingisawaytodistributetheexpensesovertimetomatchthebenefits.Moreover,atpresent,manyEuropeancountrieswouldhavedifficultyraisinganytaxestofundevensmallspendingprogrammes,sothatfromtheperspectiveoftaxsmoothing,issuingbondsisalsodesirable.

WhyEUbonds?SincethisisaEuropeanpublicgood,itshouldbefinancedthroughanEU-wideinstrument.

Why refugeebonds?Thesebonds aremeant tobe very specifically targeted todealwith therefugeecrisisandtheexpensesdescribedintheprevioussub-section.

Therefore, EU refugee bonds are the natural answer to the economic problem thatwe havedescribedsofar.Thesebondscouldbeissuedintwoalternativeways.Astraightforwardonewouldbeto

11AsimilarproposalcalledMigrationandMobilityBonds(MMBs)hasbeenairedbyKirkegaardandPhilippon(2016).Theydohowevernotoutlineinmuchdetailhowthesebondsshouldbedesigned.DeGeusetal.(2016)insteadproposeaEuropeansolidarityfundforfinancingtherefugeecrisis.TheItaliangovernmentinAprilalsoproposedaformofbondstodealwiththerefugeecrisis,butaspartofawidercompactonmigrationpolicies.

have the European Commission issue them, and pay them from future EU budget funds. This wouldrequireminimalinstitutionalchange.However,itmaybethattheEUbudgetisnotenough,givenpriorcommitments,orthatthereispoliticalresistancetousingitsfundsthisway.AnalternativewouldbeforanotherEuropeanagency(forinstancetheEuropeanInvestmentBank)toissuethesebondsinthesamemouldasthebondsissuedbytheEuropeanFinancialStabilityFacility.Inthiscase,thebondswouldbeguaranteedbythememberstatesaccordingtofixedsharesoftheirweightinEurope.

Thesebondswouldbeissuedinthespiritof“projectbonds”.Theirfundswouldbeearmarkedtoparticularprojectsthatsecurethebordersandintegrateimmigrants.Theycouldnotbeusedtofundanyarbitrary expenseat any arbitrarydate.One couldenvisiona strict processbywhich aprojectwouldqualify for this program. As a result, regions that undertakemore of these projects, for instance byreceivingmore immigrants,would receivemoreof the funds. Inorder to receivemore funds, regionswouldhavetotakeinmoreoftheseprojects.Hence,theEUrefugeebondswouldnotfundtransferstoregionsbutrathertoprojectsandpeople.Withtherecentfailureofsharingrefugeesacrossregions,apossiblysuperioralternativeisinsteadtosharethecostsinawaythatistiedtotheprojectsofsecurityandintegration.12

Thisshiftfromregionstoprojectshasseveralbenefits.First,itprovidesincentivesforregionstoundertaketheeffortneededtoaddresstherefugeecrisis.Second,itlimitstheamountofredistributionacross regions that would occur, as a result of the competition between different regions. Third, itseparatesthisprogramfrommanyotherEuropeanprogramswhereredistributionfromtherichertothepoorerbecomestheoverridingprinciple,indetrimentoftheprogram’sothergoals.Therecouldbelargeswingsfromoneyeartothenextonwhichregionismoreattractivetoimmigrantrefugees,andsettingupprojectsbackedbybondswouldallowfundstobequicklyreallocatedacrossregions.Fourth,itbenefitsthoseregionsthathavesuffereddisproportionatelyfromthecrisis,duetobeingclosertothebordersorreceivingmoreimmigrants,consistentwiththesolidarityprincipleintheEuropeanUnion.

Atthesametime,differentfromprojectbonds,theseEUrefugeebondsarenottiedtoaparticularstreamof incomefromtheproject.Becausesecurityand integrationareEuropeanpublicgoods, theirbenefitsaccruetoallintheformofprosperityandsafety.Therefore,theirpaymentshouldnaturallybedonethroughtaxation,includingthefuturetaxationofthenow-integratedimmigrants.Importantly,thisisasmallprogram,andonewhosepaymentsaresmoothedovermanyyears.Therefore, itshouldnotimpinge inasubstantialwayon theregionspayingandshouldnotweighon thesovereignriskat thenational level.Moreover,becausetheyarebackedbytheEuropeanUnion,thesebondswillnotaffectnational fiscaldebtsandnationalpublicdebt.Amoredifficult issue iswhetherthedifferentcountry’sliabilitiesshouldbe jointandsolidary.Weleavethisopenfordiscussionacknowledgingthatthereareadvantagesanddisadvantagesofdoingso.

HowdoEUrefugeebondscomparetootherbondsinanewEUfinancialarchitecture?TheotherchaptersinthisreportdiscusstheneedforaEuropeansafeassetthatbreaksthediabolicloopconnectingbanks and sovereigns. This report suggests pooling bundles of government debt with fixed weights,tranching and securitizing them to create a European safe asset that partly breaks the diabolic loopbetweenbanksandsovereignsaswellasthedestabilizingflighttoqualityacrossbordersduringcrisis.Incomparison,refugeebondsaretoosmall,andtootiedtoprojects,toprovidethissafeasset.Theyaremeanttosharethecommonburdenoftherefugeecrisis,nottocreateasafeasset.

12Inthissense,refugeebondsresembletradablequotas(orcapandtradesystems)forrefugees.

Atthesametime,therehavelongbeenproposalsfortheEuropeanUniontoissueEurobondsthatdependon the process of European integration andmove towards the creation of a federal state byimposingjointandseveralliabilitiesoverthesedebtsacrossthecitizensoftheEU.Again,refugeebondsaremuchtoosmallandnarrowinscopetoprovidethisfederalgoal.Theirfundswouldmostlyfinancealreadyexistinginitiatives,butatalargerscale,andtheyarespecificallytiedtoaveryspecificemergency,therefugeecrisis.

EUrefugeebondsdonotinterferewitheitheroftheseotherdebtinstruments.ArichfinancialarchitectureinEuropeshouldhaveavarietyofinstruments,andourclaimisthatEUrefugeebondsmightwellbeoneofthem.Investorswouldbewillingtobuythesebondsatauction-determinedprices,inthesamewaytheywerewillingtobuythebondsissuedbytheEFSF.Likewise,EUrefugeebondsarenotthesolutiontotheEUrefugeecrisis,andtheyareperfectlyconsistentwithothersolutionssuchasalargeMarshall-Plan-inspiredinvestmentdrive,paymentstoTurkeytocontaintherefugees,oracomprehensiveinternational action of refugee burden sharing including even a proposal for a market in refugeeprotectionquotesasalreadyoutlinedbySchuck(1997).Foranyoftheseothersolutions,EUrefugeebondswouldhelpinthefinancialarchitectureofhowtodealwiththisproblemandhowtofundit.

Conclusion

A common driving force of the MEZ reports is that financial markets can offer solutions toEuropeanproblems, rather than justbeinga sourceofproblemsof theirown. TheEU refugeebondsdiscussed in this chapter are an example of flexible financial engineering, envisioned a contribution,howeversmallinrelativesize,tomatchoneofthemostchallengingissuesaffectingtheEuropeanUnion.

Theproblemofrefugeesiscommontoall,isemerginginallitsforcenowandisboundtopersistbothintheimmediateanddistantfuture.Withpeopleandexpensesshiftingquicklyacrossregions,theproblemhasalreadyexceededtheabilityofsinglestatestocopewithitontheirown,asinward-lookingsolutions cannot but create cross-border spillovers leading to instability abroad. The refugee crisisrequiresacommonsolutionthatinternalizescostsandbenefits.

TheexistingEuropeaninstitutionsdonothavetheresourcestorespondtotheproblem.Extrafunds are necessary to implement minimal reforms responding to the different dimension of thechallenge, ranging from settlement to border security. Responding to the refugee crisis requiresexpenditurethathavemostlikelyalargefront-loadedcomponent,withsolidarityacrossregions,andtiedtoveryspecificprojects.Issuingacommonbondisaflexibletooltofinancethisexpenditure.

Besidesitsimmediatecontributiontotherefugeecrisis,theEUrefugeebondscanalsoserveasaleadinginstanceofinitiativesreinforcingEuropeancoordinationwherethisismostly(andmostnaturally)needed,tosolveuncontestedcommonproblems.Inrelativeterms,theprogrammesfinancedbythesebondsarequitesmallinscope,sothescaleoftheinitiativeshouldberelativelyeasytomanage.Yet,thereisalottobelearntfromitsimplementation,especiallyregardinghowfinancialmarketsvaluetheriskofobligations at the European level, and what type of institutions and institutional arrangements arerequiredtomakesurethatmemberstatescontribute fundsandfoster thedemandandcirculationofrefugeebondsassafe,riskfree,Europeanassets.

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Comments

This section reflects the comments on the draft report by the participants in the EUI-RSCASConference“MonitoringtheEurozone2016:ReinforcingtheEurozoneandProtectingandOpenSociety” at the EUI, 5 February 2016. The final report benefitted substantially from thesediscussionsandwasextensivelyrewritten.

1. Motivation:Eurozone,wheredowestand?

DanielGrosnotedhowtheIMFframeworkhaschangedfrequentlyovertimeandsaiditmaynotbeappropriatetobuildalong-termsolutiononsomethingwhichisoftenrevised.Headdedthatcontagionisextremelyimportantandislikelytotakeplacewithanautomaticextensionofmaturitiesintheso-called“greyzone”.Furthermore,thepapershouldtakeintoaccountthefactthatpolicymakersmaynotnecessarilyseektomaximisethewelfareoftheirowncountry.Forexample,theymayprefertowinthenextelectioninsteadofdoingwhatisgoodfortheeconomy.Theauthorsshouldthinkabouthowtoincorporatethisdistinctionintotheirframework.

RamonMarimonsaidthathavingabufferintheformofconcessionalESMlendingisextremelyuseful,butmayleadEuropeancountriestopostponetheproblemuntillaterthiscentury.Bythen,theEuropeandemographicprofilewillworsen,makingitmuchhardertodealwithafiscalcrisis.

AdiscussantsaidthattheEuropeanUniontendstopickonethresholdandtoapplyittoeverycountry,asithappened,forexample,intheMaastrichtTreaty.HethinksthismaybeunreasonableinaUnionwhichconsistsofcountrieswithdifferentadministrativestructuresandabilitytotaxtheircitizens.Hecalledforadifferentkindofframeworkwhichincorporatesamoredifferentiatedapproach.

JuanFranciscoJimenosaidthatconditionallendingtypicallyforcesgovernmentstoadoptausterityanddeflationarystructuralreformsduringarecession-thewrongtimetoimplementthesemeasures.Hesuggestedadifferentapproach,whichhefirstpresentedinapaperjointlywrittenwithTitoBoeri,andwhichallowstopromotegrowthandreformwithoutgeneratingtheriskofmoralhazard.Thisstrategyincludescreatingapan-Europeanunemploymentbenefitscheme,complementarytothenationalones,inexchangefortheimplementationoflabourmarketreforms.Thisapproachcansolvetheproblemofmoralhazardandcanbeusedbothduringaboomandduringabust.

SonyKapoorsuggestedthepossibilityofintroducing“livingwills”forsovereigns,anideatakenfromthebankingworld.ESMaccessandrestructuringcouldthenbelinkedtopre-approved“livingwills”,whichwouldoutlineforexamplewhichtaxeswouldincreaseduringasovereignrestructuring.Thisapproachwouldallowtodifferentiatebetweencountries,takingintoaccountspecificities.Politiciansmayseekforcross-partyconsensuswhendrawingupthesedocuments.Linkingthese“livingwills”tothepre-approvedthresholdsoutlinedinthepapercouldbeuseful.Thiswouldbeparticularlyrelevantforpre-approvedlinesofcreditfromtheESM.

PhilippeLegrainsaidthatalthoughhelikedtheideaofasovereigndebt-restructuringmechanism,hethoughtpre-establishedthresholdscouldbedestabilising.Asacountryapproachesoneoftheselimits,themarketwillreactsellingoffgovernmentbonds,creatingaself-fulfillingcrisis.

StefanoMicossiagreedthattheframeworkdescribedintheproposalwouldleadtoasustainableandstablesysteminequilibrium,butwasconcernedaboutthetransition.Heinsistedonehadtocreatesomeformofdebtmutualisationandcommonshock-absorbingcapacityinexchangeforjointoversight,otherwisethesystemwouldbeunstable.However,itisunclearwhetherpoliticianscanagreeonsuchadeal.Hecited,asanexample,theintroductionofthenew“bailin”regimeinItaly.Theagreementin2013impliedchangingtherulesonexistingbonds,sothattheycouldbewrittendowntozeroeventhoughinvestorsthoughttheyweresafe.Whenfoursmallbankswereresolvedattheendof2015,thisbroughtinstabilitytothesystem.Theriskisthatthenewmechanismoutlinedinthepaperwouldintroduceasimilarkindofinstabilityinthesovereigndebtmarket,asitisimpossibletointroduceitonlyfornewly-issuedbonds.

JonathanPortessaidthatintroducinganexactthresholdcouldcreatetwotypesofperverseincentivesforgovernments.Thefirstistouseallthefiscalheadroomandincreasespendingallthewayto90%.Thesecondistouseaccountingtrickstostayontherightsideofthethreshold,somethingwhichhashappenedinGreece,butalsointheUK.Portesaddedhehasdoubtsovertheexcessiverelianceonhardfiscalrules.Instead,heprefersfiscalcouncils,suchasthoseoperatinginSwedenorBelgium.Ifcredible,thesecouncilscanimposedisciplineonpoliticians,whileallowingcountriestotakeownershipoftheirtax-and-spenddecisions.

ShahinValléesaidhewasscepticalofmodellingthismechanismonaframeworkwhichhasbeenrewrittenthreetimes.Oneriskisthatwhenthenewmechanismneedstobite,therulesarerewritten.Anotherriskisthattheframeworkiswritteninsuchawaythatno-oneunderstandsit,sothateachgovernmentcanapplyitashelikesit.Headdedthatthereweretwomotivationsbehindtheproposedmechanism:oneisdealingwithexcessivedebtstocksandtheotheristorestorethepowerofpricesignals.Hesaidthatitisnotclearhowthemarketdisciplinewouldwork,sothenewmechanismmaynotachievewhattheauthorshopefor.

EdouardVidonsaidthatoneshouldbecarefulwhendrawinglessonsforEuropefromtheIMF’sexceptionalaccessframework(EAF).Thisframeworkhasnotchangedinseveralrespects.Forexample,acountryhastofacelargebalanceofpaymentsneeds,althoughitislessclearhowthattranslateswithintheeurozone(givenEurosystemrefinancing).Secondly,theIMFframeworkdemandsthatacountrymusthavetheprospectofregainingmarketaccess,sowemaywanttodiscusshowtoassess(andsupport)thatinthecontextofanESMprogram.Finally,oneimportantcriterionintheEAFistohavetheinstitutionalandpoliticalcapacitytoimplementreformsandthereisaquestionmarkoverwhetherandhowEuropecandothat.Vidonrecommendshavingproperinstitutionswithmandatesandinstrumentsinsteadofruleswithoutinstitutions.Theinstrumentsmustcombinetheneedforpolicycoordinationwiththeincentivetoreform.Meanwhile,themandatewouldhavetoincorporateseveralobjectivesoffiscalpolicy,includingbothsustainabilityandstabilisation.Besides,theeurozoneneedstodesignaframeworkthatworksbothinthesteadystateandwhentherearelargeshocks.

JerominZettelmeyersaidthatalthoughframeworksareregularlyviolated,thisdoesnotmeantheyareineffective.Rather,oneshouldthinkofarules-basedframeworkasindicatingastandardcourseofaction,albeitwithsomesortofescapeclause.Onequestioniswhetherit

wouldbebettertochangetheframeworksthatmakestheescapeclausemoreexplicit.Butwhilethislatterstrategyistheoreticallymoreappealing,economistsrecognisethatcontractsarealwaysincomplete.Hence,thefactthatarules-basedframeworkisoftenviolateddoesnotnecessarilyinvalidateit.

Thevulnerablepartoftheauthor'sproposalisnottheframeworkpersebutratherthe90%threshold.Thereportrationalisesthisusingthe60%thresholdfromtheMaastrichtTreaty,addingalargesafetyzoneforbigshocksandbankingcrises,whichmaynotbeentirelyimplausible.However,itisunclearhowonereachesthisexactnumber.Itispositivethatmarketsrespondwhenacountryapproachesthe90%threshold.Thefactthathighlyindebtedcountriesmaybecutofffrommarketborrowingearliermaybeintended.However,oneshouldensureself-fulfillingrunsareavoided.

Zettelmeyeraddedthatdebtrestructuringisanetpositivesolongasitdoesnotproducedeadweightlosseswhicharehigherthanthosefromcontinuousover-borrowing.However,restructuringcancauselarge-scaleproblems,forexampleifthebankingsystemholdsalargeportionofsovereigndebt.Inthatcase,reprofilingcanbealessunsettlingoptionthanoutrightrestructuring.

GeorgeAlogoskoufisaskedwhetherapplyingthisframeworktotheGreekcrisiswouldhavemadethingsdifferent.TheGreekprogrammefailedintheimplementationphase,sothequestiononeshouldaskishowtoensurethattheadjustmentprogrammeissufficienttoregainmarketaccess.

TitoBoerisuggestedoneshouldre-considerthedefinitionofdebt,includingsocialsecurityentitlements,i.e.implicitdebt.Byincludingthisotherpile,overalldebtwouldbehigher.However,thevariabilityofgovernmentdebtacrosstheeurozonewouldbereduced,sinceimplicitdebtislesswidelydispersedthanexplicitdebt.Furthermore,includingimplicitdebtwouldgivegovernmentsnewinstrumentstodealwiththeirpublicaccounts.Atthemoment,politicianscanonlychoosebetweenfiscalrestraintanddebtrestructuring.Implicitdebtallowsforintertemporalreductionsofdebt,givingpolicymakersmoreoptions.BoerialsoagreedwithJimenothattheexistingtypeofconditionalitycreatesaproblemofincentives,while“positive”conditionalitytakescareofthisproblem.

LucaOnorantesaidthattheabolitionofthesystemicclausemayimplyamuchsmallerroleoftheIMFintheeurozoneforawhile.ThereisanopportunityandtheneedtoincreasetheroleoftheESM.Headdedthatwhilehelikedtheideaofhavingaframeworkbasedonthresholds,thesefiguresaresubjecttoplentyofdiscretion,asoneneedstocollectdataandrunmodelssubjecttohypotheses.Mostimportantly,theverygovernmentsthatarelikelytobreachthesethresholdshaveagreaterincentivetomassagedata.Thresholdsmustthereforebecombinedwithfiscalcouncils,andfiscalcouncilsshouldbeideallyindependentandevenlocatedoutsidethecountrytheymonitor,whichispossibleprovidedtheyonlyhavethetechnicalroletocollectdataandrunmodels.

Anadditionalproblemisthatthereisalimittowhatonecandoindemocracies,aselectoratestendtovoteoutgovernmentswhentheyimplementtoostrongadjustmentmeasures.Hence,itisbettertohaveasystemofearlywarningsthantowaitformarketstowakeupwhenitistoolate.

HélèneReyrespondedbysayingthatthemainpurposeoftheproposedstructureistocreateanend-gameforpoliticians,sothattheydonothaveanincentivetopostponeadjustmentsindefinitely.Thismeansthattheframeworkcanbecomplementedwithothermeasures,includingfiscalcouncilsandcyclically-adjustedrules.

RicardoReisrespondedthatthe90%thresholdisnotbasedonmarketinterestrates.Thisallowstoavoidtheriskofself-fulfillingcrises.Oneadvantageofhavingafixedthresholdisthatmarketrateswillgoupwhendebtlevelsapproachthe90%limit,puttingmorepressureongovernmentstoadjust.Furthermore,theexistenceofpreciserulesonrestructuringallowsbondholderstocalculatetheirexpectedloses.Thiswillbeincorporatedintheincreaseininterestrates.Finally,restructuringstillcomeswithconditionality.Thisallowstopreservedemocracywhileprovidingtherightincentivestogovernments.

BeatriceWederDiMaurorespondedthatitisclearthattheexactthresholdisnotmerelycountry-specific,butunobservable,time-variantanddependentontheexistingpoliticalconstellationandperhapseventhepersonalityofpoliticians.Ifoneincludedallthesevariables,itwouldbeimpossibletohaveaframeworkencompassingthewholeoftheeurozone.The

adjustmentforconcessionaryinterestratesistheonlykindofadjustmentwhichiseasytoincorporate.Thealternativeistoabandonframeworksandkeepdiscretion.However,thisimplieshavingthekindofproblemsonehasnow,i.e.“kickingthecandowntheroad”restructuringtolittle,toolateandattoohighacosttotheEuropeanandnationaltax-payer.Evenmoreimportantly,withoutatransparentrestructuringregimemarketswillnotpricesovereignriskadequatelyinintranquiltimesandinsteadrunfortheexitwhendebtlevelsarealreadyexcessivelyhigh.

WederDiMauroalsosaidthattransformingtheESMintotheIMFoftheeurozonewouldrequiremorediscussion.Oneoptionwouldbetohaveflexiblecreditlines,whichshouldbeavailableonlytocountrieswithadebt-to-GDPratiobelow60%.IftheEMSwastocontinuelendingat30yearsmaturitiesitiscreatingthedangerofkeepingcountriesinlongtermdebtdependence.PossiblytheESMshouldincorporatemoreautomaticbuffersintoitslending,akintoGDP-linkedbonds.

InresponsetoTitoBoerishenotedthatwhileimplicitdebtmattersforsustainability,thereislittleevidenceitmattersforthepricingofexplicitdebtandthereforecontributestopossiblebankruns.

Session2:GovernanceoftheEuroArea:FinancialRegulation

AlexanderSchulzsaidthattheproposaldangerouslygivesupontriedandtestedinstrumentssuchasriskweights.Thesehavetheadvantageofrequiringthatbanksholdsufficientcapital,whilegivingtherightincentivestogovernments.Bankshaveinternalmodelsthatcanbeusedtocalculateadditionalcapitalrequirements.Concentrationlimitsarealsoausefulinstrument,thoughonecanobviouslydiscusstheircalibration:theeurozonehastheadvantageofhavingdifferentgovernmentdebtinstrumentsallinthesamecurrency,makingiteasiertodiversify.Schulzaddedthatgivingaregulatoryprivilegetosovereignscanleadtoundesirablecrowdingouteffectsoncorporatelending,sotheserulescouldalsohaveanadditionalpositiveeffectfortherealeconomy.

Schulzwasalsoscepticalofhavingonedebtagencythatcreatesasafeassetbycombiningandtranchingindividualbonds,asthisdestroystheprincipleofmarketpricing.Inordertohavecommonfinancingcapacity,countriesmustbewillingtogiveupatleastsomeoftheirsovereigntyingoodtimesaswellasbadtimes.Finally,itshouldnotbethesupervisorswhoareinchargeofchangingtheriskweights,buttheseneedtobelaiddowninregulation.

EviPappasaidoneshouldfocusontheproblemsassociatedwithtransitioningfromonesteadystatetothenext.Ingeneral,sheagreedthatthereisnotenoughportfoliodiversificationintheEurozone.Furthermore,thefactthatthebanksaresoconnectedtothesovereignsendsuplinkingbankingandfiscalcrises.Thesolutionisnotjustcreatingbasketofbonds,buttransformingbanksininstitutionsthatarelesstiedtoasinglecountry,forexamplebymakingiteasierforthemtoenterdifferentmarkets.Morediversificationwillnecessarilyleadtomoreintegration.

LucaOnorantesaidthattheframeworkestablishedinthepapercreatesonebigsafeandliquidasset.TheriskiswhentheECBbuysthissafeasset,itmostlyfavourscountriesthatdoneedhelp.Onorantewasalsoconcernedthatthedemandforthesafeassetmaylimittheliquidityforotherbonds,exacerbatingtherisksforcountriesindifficulty.

ChristianOdendahlsaidthatwhilethemechanismpresentedischaracterisedbystrongmarketdiscipline,thistendstocometoolate,thatiswhenacountryisdangerouslyclosetothe90%threshold.Onewouldneedamechanismwheremarketdisciplinekicksinearlier.

RamonMarimonsaidthatthereisavaluabledisciplinaryeffectderivingfromhavingsubstantialamountsofgovernmentdebtinthehandsofdomesticbanksandinvestors.Thepoliticianswillbemorecarefulaboutdefaultingontheirdebtasitwouldimpacttheirvotersdisproportionally.Asaresult,theimpactoffreeridingandmoralhazardissmaller.

SonyKapoorsaidhehaschangedhismindaboutthedesirabilityandfeasibilityofbrakingthesovereign-bankloop.Thereisadisproportionatelinkbetweenacountry’sbanksandthesovereign.Firstly,banks’profitsareaffectedbyacountry’seconomicconditions,asthesedeterminetherateofdefaultaswellasthedemandfornewloans.Secondly,theultimate

backstopforacountry’sdepositguaranteeschemeisthegovernment,asittakesplentyoftimetobuildafundusingresourcesfromthebankingsector.Furthermore,breakingtheloopmaynotbedesirable,asitcanputcountriesinadifficulttransition.Forthisreason,itisimportanttorethinkthebankingunionanditsprinciples.

Kapooralsosaidthatitispositivetohaveabankingunionduringthebadtimes,asthisallowslossestobesharedacrosstheeurozone.However,itislessclearthatitisdesirabletohaveabankingunionduringthegoodtimes,assaversstoplookingatrisksandtendtopourtheirmoneyintothesamespeculativeassets,suchasSpanishhousing.

EdouardVidonsaidthatanyproposalonthesemattersneedstobeconsistentwithmonetarypolicyobjectivesandoperations,aswellaswithliquidityrequirements.Thisparticularproposalhastheadvantageofmeetingsuchcriteria.However,theframeworkaspresentedsofarismainlyaboutriskreduction,whilethepolicydiscussionnowisabouthowtocombineriskreductionandrisksharing.Therearethreemainideasonthetabletoenhancerisk-sharing:introducingaEuropeandepositinsurancescheme;makingiteasierfortheESMtorecapitalisebanksdirectly;andhavingacommonfiscalbackstop.Theproposalsoftheworkshoplinkthebankingsectortothefiscalframeworkinaneatway,buttheyshouldincludeplanstoenhancerisk-sharinginthesteadystate.

Jean-PierreVidalsaidthatthelinkbetweenthebanksandthegovernmentsisindeedproblematicandneedsbreaking.Onewayofdoingthisisviaregulatorychanges.Theend-resultmustbetostophavingbanksthatare,forexample,GermanorFrench.Whiletheeurozonehasmovedtoaregimeofcommonsupervision,ithasnotyetchangedthenatureofitsbanks.Thereformsneededgobeyondlimitingtheexposuretosovereigndebtandmustincludetheharmonisationofnationalrules,forexample,onrepossessions.

RichardPortessaidthattheproposalmusttakeintoaccountthefactthattheECBisnowbuyingbonds.Healsosaidthattherearehugedisadvantagestoriskweights.Basingrisk-weightsonso-calledfundamentalmeasureswouldbeamistakeasthesemeasuresareunreliablesincethereislittlecorrelationbetweenthemanddefaultrisk.Marketmeasures,

suchascreditdefaultswaps,areevenmoreunreliableandvolatile.Inprinciple,theregulatorsshoulddetermineriskweights,buttheyfaceunsustainablepoliticalpressures.

Portesaddedthateveninthecaseofadefaultsomedebtwouldstillbeserviced,sooneshouldnotdemandthatbankslimittheirexposuretosovereigndebtassumingtheywouldloseeverything.Furthermore,althoughhomebiasrosesubstantially2011-2014,ithasfallen,andtherearenowonlyafewproblematiccases.Itwouldbeamistaketodesignalawthatisoverlyinfluencedbyafewhardcases.

JerominZettelmeyersaiditisimportanttounderstandthelegalimplicationofthetranchingmechanism.Forexampleoneneedstoevaluatewhethersomeofthetranchinghastooccuratthenationallevel,orifinternationalinvestorscandoeverything.

LucreziaReichlinclarifiedthattheproposaldoesnotassumethatthereisasingledebtagencyissuingthesafeasset.Rather,thesafeassetisasyntheticbondwhichmarketplayershaveanincentivetocreateoncetherulesarechanged.Infact,solongasalldebtisriskfree,marketplayershavenoreasontocreateasyntheticsafeasset.

Shesaidthatevenifweareback-tothepre-crisislevelintermsofhomebias,thereisplentyofevidencethatduringa“flighttosafety”thistendencyreappears.Thisiswhytheproposalpreferspromotingriskdiversificationtoimposinglimitstoexposure,asitgoesinthedirectionofcreatingasafeasset.

Reichlinalsoaddedthatimposingriskweightsisboundtoproducelargeportfolioshifts,whichhaveaneffectbothoncapitalrequirementsandprofitability.Thekeyplankofthisproposalisthataslongasabankdiversifiesitsportfolio,thiscanenjoyarisk-freetreatmentonitssovereignbondholdings.

Lastly,shesaidthatdomesticdebtatthemomentdoesnotactasadisciplinedeviceintheeurozone,sincethereisnocrediblethreatofrestructuring.Sheagreedthatmoreworkhadtobedonetounderstandtheexactinfrastructureoftranching.

HélèneReyrespondedthattheincentivesinplaceintheeuroareaaretorestructuresovereigndebtfartoolate.Sheaddedthatthesovereign-bankloopisstillverypowerfulanddangerous.Itisrightthatsovereigndebtisnottheonlyissuewhenonethinksofbreakinglinksbetweennationalriskandbanks.Oneimportantchannelistheexposureofbankstonationalcorporatedebtandnationalrealestatemarkets.Hence,oneshouldthinkofwaystoattenuatethelinkbetweenbankbalancesheetsandnationalriskviasecuritisation.Harmonisingbankruptcyrulesforexamplewouldbeanimportantsteptohelpdoingjustthatandthisshouldbeontheagendaforthecapitalmarketunion,Butallthatdoesnotmeanthatthesovereign-bankloopisnotimportantandthisiswhatwefocusoninthereport.

Reyaddedthatitistruethatitishardfortheregulatortocreateadequateriskweightsandforthesupervisortoimplementthem.Linkingriskweightstothefiscalrules,asitisdoneintheproposal,istransparentandgoesaroundalotofusualcriticisms.

RicardoReisrespondednotingthatthebasicprincipleoftheproposalisthathavingadiversifiedportfoliomustbeagoodthing.Thecreationofasafeassetisjustanacknowledgementofthisprinciple.Headdedthatwhilethehomebiasmaybebeneficialfromasocialpointofview,asitdecreasestheincentivetodefault,thereisatendencytohavetoomuchhomebiasbecausetherearesignificantexternalitiestoholdingontodomesticsovereignbonds:thisisevidentfromtherapidriseindomesticsovereignbondholdingsbybanksduringthecrisis.Headdedthatitisnottruethatonlybanksfromcrisis-hitcountriessuchasItalyholdtoomuchdomesticdebt.USbanksoftenhavezeroTreasuriesastheseofferextremelylowreturnsatthemoment.Hence,bycomparison,evenGermanbanksseemtohaveaportfoliowhichisexcessivelyskewedinfavourofdomesticsovereignpaper.

Reisalsosaidthatthe60%thresholdisclearlyareferencepoint.However,itwouldbewrongtosaythattheoptimalpointisforgovernmentstohavezerodebt,asthereisaminimumamountofbondsasovereignhastosupplytoensure,forexample,theinsurancesystemremainshealthy.Thequestioniswhatistheoptimalleveltoensurethegovernmentdoesnotactasthemarginalbuyer.

Session3:DebtOverhangandFiscalStance

StefanoMicossisaidthattheframeworkpresentedinthesessionfullyresolvestheproblemofthestabilityofthesystem.However,thereductionofpublicdebtscreatesnewfiscalspace,whichrecklessgovernmentswillbetemptedtouse.Theframeworkmustensurepoliticiansdonotexploitthisopportunity.Finally,heaskedwheredebtservicingcostsgo.

GeorgeAlogoskoufisaskedwhethergovernmentswouldwithdrawshort-termorlong-termdebt.

SonyKapooraskedwhethertheauthorsarethinkingofjointliabilityforthewholestock.

Jean-PierreVidalwantedtoknowwhatistheexactdifferencebetweentheauthors’proposalandtheonefromtheGermanCouncilofEconomicAdvisers.HesaidthatwhiletheGermanplanwaspoliticallysellable,thislookscompletelyunrealistic,sincetherearelarge-scaletransfers,aswellasasignificantmutualisationofdebt.Finally,itisnotclearwhycountriessuchasFranceorGermanywouldliketoconstraintheirfiscalcapacityinthefuture.Theymayprefertousepublicmoneytofundbailoutsinsteadofemployingresourcestobackthisfund.

JerominZettelmeyersaidthathewouldpreferastructurewithzerotransfersandwheretheonlybenefitscomefromrisksharing.Theproposedstructureisalsogoingtoinvolvesignificantbuybacks,creatinghugewindfallsforsomeinvestors.Asaresult,theonlywayaroundthisproblemhastobeanegotiatedbuyback,butthiswillbeextremelycomplextoorganise.OnepossiblealternativeistoasktheEuropeanfundtobuydebtatmaturity,avoidingthebuybackproblem.However,thetransitionwouldnecessarilytakelonger.

LarsFeldsaidthattheoriginaldebt-redemptionschemeworkedwellbecauseinterestratesweremuchhigher.Now,thedealwouldnotworkanymore,sincecountriessuchasItalyhavelittlereasontoacceptconditionalityinexchangeforasmallreductionininterestrates.Theproblemwiththisproposalisthatgovernmentswouldhaveanincentivetousetheextrafiscalspacetospendmore.

JonathanPortessaidthatsecuritisingfuturetaxrevenuesshouldnotbetreatedasaformofdebtreduction.Anycountrycouldeasilycutitsdebtbyarguingthatagivenportionofitsdebtisequivalenttoacertainproportionofitsfuturetaxrevenues.Theproposedframeworkshouldincludearoleforeconomicallysignificanttransfersandrisk-sharing.

PhilippeLegrainsaidthatabetteralternativewouldbetomaketheEuropeanCentralBank’squantitativeeasingprogrammepermanent.TheECBwouldkeepdebtforever,asolutionwhichwouldbelesspoliticallypainfulandmoreeffective.Werethismovetogenerateinflation,thiswouldbeaplusinaworldofverylowpricepressuresandhighdebts.

LucaOnorantesaidthattheproposedschemecanbeideallydecomposedinthreeparts.Thefirstone-mutualisationofrisks-wouldbeaclearadvantage.Thesecondone–thesecuritisationofdebt-isprobablynotimportantforthedebtorcountry.Thethirdone-thepotentialmonetisationofdebtiftheECBparticipateswithanimplicitguarantee–canalsobeanadvantageandwouldbeeasiertoobtainwithonesyntheticbond.Headdedthatthemainproblemwiththisproposalisthatitcreatesmoralhazardforcountriestospendrecklessly.Thiscanbesolvedbyoptingforgradualpurchasesofsovereignbonds,whichcouldstopifacountryfailstoadoptsensiblepolicies.

ChristianOdendahlsaidthatevenbuybacksatmaturitydonotremove,butsimplyreducewindfalls,astheyeliminatetheriskcomingfromtherolloverofdebt.Headdedthattheframeworkmayopenupnewoptionswhicharecurrentlyunfeasible:forexamplewealthtaxesmaybeeasiertoselltothepubliciftheirrevenueistargetedataccumulatingthe0.5%ofGDPneededtobringdowndebtlevels.

HélèneReyrespondedthatcountrieswouldnotchoosewhichbondstowithdraw:theStabilityFundisinchargeofthepurchases.ShesaidthestabilityfundwillpayinteresttoholdersoftheStabilityFundbonds.Thereisaformofjointliability,butonlyofatemporarynature.

Reyalsosaidthattheproposaldoesnotgivegovernmentstheincentivetospendrecklessly.Forastart,countriesstillhavetopay0.5%oftheirGDPintotheStabilityFund,whilehavingtoservicewhateverstaysontheirbalancesheet.Secondly,oneshouldrememberthatthe

proposalneedstobecombinedwiththerestructuringframework.Countrieswithdebtapproachingthe90%thresholdwillfacemarketpressuretoreduceit,asinterestrateswillgoup.Finally,theschemeisabetteralternativetoinfinitebond-buyingbytheECBasitisnotrightthatonereliesonCentralBankpurchasestoaddressaproblemofdebt-sustainability.

BeatriceWederDiMaurosaidthattheproposalisdifferentfromtheonedesignedbytheGermanCouncilofEconomicAdvisersasthelatterwasnotretiringdebt,butfacilitatingitspaymentover25years.TheproblemwiththeGermanplanisthatthistransitiontakes25years,whichdoesnotallowforanimmediatestabilisationoftheeurozoneanddoesnotavoiddebtruns.

SheaddedthatthisproposalismoreambitiousthantheonefromtheCEAasittakeslesstime.Ifthereisthepoliticalwill,itcanbeimplementedinjustsixmonths.Conversely,itislessambitiousaseachcountrypaysforitsowndebt,whiletransfersareminimal.Forexample,Germanywouldonlypaytheequivalentof€20percitizenperyearoverhalfacentury.

Shealsosaidthattheschemeleadstostrongerfiscaldiscipline.Governmentswillbecommittedtokeeptheirfiscalhousesinorderastheytransitiontothenewrestructuringregime.Thestabilityfundwillbejointlybackedbygovernments,withtheECBbackingitsliquidity.

Finally,sheaddedthatitisinevitablethattherewillbesomewindfallsfromthebuybacks.Furthermore,itispossibletoreducetheneedsoftheschemeto,say€1tn,ifoneonlyaimedtoreducealldebtstockstojustbelow95%.However,thedistributionofthisschemewouldbeunequal.Forexample,Italywouldenjoyaverylargeportionoftheseresources.

Session4:RiskandOpportunities:RefugeesandSecurity.FrontexandMore

KlausZimmermannsaidthatthisismoreacrisisofpolicymakingthanarefugeecrisis.ThecurrentinflowintoGermanyisnotthelargestinrecenthistory.Infact,thewaveinthe1990sfollowingthewarintheex-Yugoslaviawasbigger.Headdedthatsincetheinflowisnotlarge,thecostsandbenefitsofthisepisodeareboundtobelimited.Furthermore,immigration

triggeredbyepisodesofwidespreadviolencetendstobetemporary.ManyBosnianswhocametoGermanyduringthewarreturnedoncetheconflictended.Immigrantsthistimearealsounlikelytobeveryeducated.Thismeansthatwhiletheremaybeshort-termcostsfromthiswaveofrefugees,thelong-runbenefitsaremoredubious.

Zimmermannalsosaidthatrefugeebondsareagoodideatopayforthecrisis,probablybetterthanraisingtaxes.However,hehaddoubtsoverwhowouldbuythesesecurities.Europeshouldbetterthinkabouthowtodistributetheburdenofthisinflow,sincethisisthemainproblemassociatedwiththiscrisis.HearguedthatitisvitalfortheEUtopreserveSchengen,butoneshouldthinkofalternativestotheDublinagreement,whichstatesthatrefugeesshouldremaininthecountrywheretheyhaveenteredtheEU.

DanielGrossaidthatwhiletheDublinagreementisnowpartoftheEUregulations,anECJrulinghasdefactosuspendeditsapplicationtoGreece.ThejudgesdecidedthatrefugeescannotbesentbacktoGreeceasthetreatmenttheredoesnotcomplywithEuropeanstandards.ThisrulingwasconfirmedbythedecisionfromtheGermangovernmenttograntasylumtorefugeesfromcountriessuchasSyriawhocrossitsborders,regardlessofthefacttheycrossedtheSchengenborderinGreece

GrosaddedthatoneshouldbecarefulaboutcomparingthecurrentcrisiswithwhathappenedduringtheBalkanwar.Inthe1990s,thenumberofpotentialrefugeeswascontainedandtheyhadaverylowbirthrate.Conversely,atthemomentwearetalkingabouthundredsofmillionsofpeoplewhocouldpotentiallycometoEurope,withveryaveryhighbirthrate.Anotherimportantdifferenceregardsthebusinesscycle:atthemomentunemploymentintheEUisveryhigh,makingitmuchharderforvoterstoacceptlarge-scaleinflows.

BrigidLaffansaidthatwhilethenumbersinvolvedmaybesmallsofar,thesituationintheMiddleEastisunstableandtheEUshouldexpectfurtherinflows.Furthermore,unlikeduringtheBalkanwar,theissueofrefugeeshasnowbecomepoliticised.Inthepast,politicianscoulddealwiththiskindofcrisisinatechnicalway,pretendingitwasnothappening.However,thiscannothappennowbecauseoftheriseofchallengerparties,whohaveoftenmovedtotherightasaconsequenceoftherefugeecrisis.

Jean-PierreVidalsaidthattherefugeecrisisisaforeignpolicyissue,notjustaneconomicproblem.ThisiswhytheEUispushingtheG20totreatitasaglobalissue.

Vidalwasalsoagainsttheideaofinventinganewfinancialinstrument.TheEUshouldinsteadcoordinateitspoliciesanduseexistinginstrumentssuchastheEUbudget.Furthermore,theEIBwasalreadyprovidingfinanceforrefugee-relatedprojects.Moregenerally,itiswrongtomixupEurozone-andEU-wideproblems.

ShahinValléesaidthepremiseofthispapershouldbethattheframeworkinitiallyadoptedbytheEUhasfailed.TheEUintendedtosharerefugees,butthisneverhappened.TheEUisnowdiscussingsharingthecostsofthecrisis.Headdedthesecostsarereal,buttherearealsomeaningfulbenefits.WhiletheEUisdiscussinghowtosharethecostsofthecrisis,itisnottalkingabouthowtosharethelong-termbenefits.Itisnotclearwhyrefugeesshouldstayinthecountrythathoststhem,whileeveryonecontributestopayingforthecosts.Thisisanunfairbargain.

FinallyValléesaidthatifgovernmentsareunwillingtoborrowandshareresourcestopayfortherefugeecrisis,itisnotclearwhytheyshouldbewillingtodosoviatheEIB.AskingtheEIBtolendmoneytoacountrysuchasTurkeymeanschangingtheremitofaninstitutionmeanttofundinvestmentinEuropeandforcingittotakelosses.Analternativeapproachwouldbetohaveanadditionallevyongasoline,assuggestedbyWolfgangSchauble,Germany’sfinanceminister.

JonathanPortesdiscussedthepossibilityofagrandbargainbetweenGreeceandtherestoftheeurozone.ThiswouldinvolvewritingoffGreekdebtinexchangefordemandingmorealacrityfromAthensindealingwiththerefugeecrisis.HeaddedthatthebestwayofstoppingrefugeesfromwalkingintocountrieswheretheyhaveabetterchanceofobtainingrefugeestatusistoprocesstheminGreece.ThiswouldallowtheEUtosendbackthosepeoplewhodonothaveawell-foundedreasontobetreatedasasylumseekers.ThebestwayofobtainingthesepositiveresultsistogivetheGreeksthosefiscaltransferswhichmakesensefromaneconomicpointofviewinawaywhichispoliticallyfeasibleinGermany.SettingupproperrefugeecampsinGreecepaidforbyGermany,whiledeportingthosewhodonothavearight

toseekasylum,wouldallowtohavesomethingwhichisbotheconomicallysensibleandpoliticallyfeasible.TheUKwouldprobablybewillingtohelpforthisprovidedthemoneycamefromtheEUbudget.However,itwouldbehardforthegovernmenttoraisepetroltaxestopayforit.

EviPappawasscepticalthatbribingacountrytotakerefugeeswouldwork.Forastart,shebelievedtheGreekgovernmentwouldsimplytaketheEuropeanmoney,withoutdoingitspartofthedeal.SheaddedthattherefugeestoowouldbeunlikelytostayinGreeceandwouldinfactcontinuetogotoGermanyortoanyothercountrytheywanttogoto.Shealsosaidthattherewillbeveryfewlong-runbenefitsfromtherefugeecrisis.

Asaresult,PappathinksthattheonlypragmaticanswertothecrisisistoformaEU-widecommitteetoregistertheincomingrefugeesandcollectdataonwhotheyareandwhatqualificationstheyhave.Sheaddedasylumseekersshouldberedistributedacrosscountriesinasymmetricway,ratherthanhavingallthehigh-skilledindividualsgoingtothesamecountry.

ChristianOdendahlsaidthatthepaperpresentedsomeratherlargesavingsarisingfromcoordinatingtheEuropeanresponseratherthanactingatanationallevel,andwonderedwherethesesavingswouldcomefrom.HealsoagreedthatbondsallowedforgreaterflexibilitythananyschemeemployingtheEUbudget.Forexample,thisframeworkallowstohaveonlyalimitednumberofcountriesparticipatinginthescheme.

SonyKapoorsaidtherefugeecrisisoffersagreatopportunityforGermany,theEuropeancountrywiththesinglebiggestdemographicproblem.Theframeworkpresentedshouldnottrytoaddresstheprobleminasymmetricway.Countrieswillhavedifferentneeds,intermsofbothwhattheycanaffordtocontributenowandhowbeneficialtheinflowisfortheirdemographicproblems.Theproposalneedstorecognizethefactthatcostsandbenefitsaregoingtobeasymmetricinthelongrun.

PhilippeLegrainsaidthisproposalwastryingtosolveafalseproblem.Ontheeconomicside,Germanycanfindtheresourcesneededtoaddressthecrisisfromitsexistingfiscalresources,sothereisnoneedforlarge-scaleEuropeanfunding.Instead,theissueispolitical,butthesmall

sumsofmoneymentionedinthepaperareunlikelytosolveit.Also,theproposaldoesnotaddressthehumanitarianaspectofthecrisis.Thisrequiressettingupaproperschemewherebyrefugeescanapplyforjobsfromtheirowncountries,sothattheydonothavetostartlonganddangerousjourneyviasea.

JuanFranciscoJimenosaidthattheproposalshouldbemoreinterventionistandlinkincentivestoquotas.Quotashavefailedtotakeoff,buttheymaybeeasiertoenforceiftheyarelinkedtofunding,thoughonewouldstillneedtosolvetheproblemoflabourmobility.Abettersolutionwouldbetoassigntradeablequotasandestablishanincentivestructure.ThiscouldbefundedviatheEUbudget.

JerominZettelmeyersaidthattheEuropeandebatehasnowshiftedfromdistributingasylumseekersamongcountriestostoppingtheoverallinflow,whichissomethingpoliticiansarenowwillingtopayfor.Thiswillbedoneinseveralways:bystabilisingtheEU’sborders,givingmoneytoTurkeyandfundingregistrationcentresinperipheralcountriessuchasGreece.Whilemostofthemoneywillbeusedtostoptheinflow,thereisaroleforaproject-bondtypeofarrangement,especiallyifthereissomeflexibilityintermsofwhichcountriesareabletoparticipate.

KlausZimmermannsaidthatoneneedstolookattheissuemorestrategically.Intheshort-run,refugeescomeinbecausetheyneedimmediatehelp,whichtheycouldgetanywhereiftheEUorganizesitwell.Inthelong-run,itisimpossibletoknowwhererefugeesareneededmost.Therefore,itisbesttoallowforfreelabormobilityacrosstheEUtoletthelabormarketdotheefficientallocation.

HeaddedthatitisimpossibletofinallyprotectthebordersintheSouthofEurope.Therearejusttoomanyentryroutes,andonewouldneedtoomanyships.ThismeansthattheAustralianmodelofinterjectingshipsandsendingthembackcannotbereplicated.Instead,oneneedstolookatprovidingalternativeavenuesforimmigrantstocomelegallyintoEurope,especiallytothosewhoarenotrealasylumseekers.ThecircularmigrationcontractsofferedbytheSpanishgovernmenttoimmigrantscomingfromNorthernAfricaareoneoption.Butthereshouldbealsodirectasylumrecruitmentinrefugeecampsandbetterhelpforthosestayingthere.

BeatriceWederDiMaurowasconcernedthattherefugeecrisisisseenbyotherEuropeancountriesalmostwithsome“Schadenfreude”,oralternativelyasanasymmetricshock,whichforcesBerlintospendmore.ThereisalsoatendencytoarguethatGermanywillbenefitmostfromtheimmigrationHowever,manyoftherefugeesarenoteasytointegrateinthelabourmarket.Sofar,Germanyhasbeenextremelywelcoming,butoneshouldrememberthatGermanyhasnotalwayshadapositiveexperiencewithimmigrants,astheyhaveoftenlackedthenecessaryskillstoenterthelabourmarket.ItisessentialforGermanstokeepapositiveattitudetowardsthisinflow,butthisrequiresthatthecrisisshouldbetreatedasaEurope-wideproblem.

WederDiMauroaddedThatoneoptionistocombinetherefugeecrisiswithotherproblemsfacingtheEUandachieveagrandbargain.OnereasontodothisisthatthefinancialcostoftherefugeecrisisinGermanyisfarfromtrivial.Thegovernmenthasalreadyallocated€15bn,whichishardlyasmallamount.Furthermore,itisunlikelythattheproblemwilldisappear,meaningthatthesumsinvolvedarelikelytogrow.

HélèneReysaidthatitisextremelyimportanttobeabletotellvotersthatEuropeiscomingupwithsolutionstotheirdemandsforgreatersecurity.Sheaddedshewasnotsurewhetherthispossibleso-called“grandbargain”wouldbebetweentheEUandGreecealoneoramongallcountries.Finally,shesaidgovernmentsshouldthinkhardaboutwaystotierefugeestoalocation,temporarily,inexchangeformoneyandtraining,inorderforthelogisticstobemanageable

LarsFeldrespondedsayingthatthereporthastriedtotakeintoaccounttheexistingpoliticalconstraints.Ofcourse,ifitwereeasytoallowtheEUtoissuebondsonalarge-scaleortoallocatemorepowersoverdefenceandsecuritytotheEU,thesewouldbethemostfavourablesolutions.However,thesediscussionshavenevertakenoffatEuropeanlevel,whichiswhyoneneedstolookforanalternative,suchasusingtheEIB.

Heclarifiedthatmanyinstitutionswouldbewillingtobuythesebonds,includingtheECB.Healsoagreedthatthesumsinvolvedarecurrentlysmall,buthesaidtheprimarypurposeofthisschemeistoloweracountry’sreluctancetoacceptrefugees.

Feldalsosaidthattheschemeproposeddoesnotintendtobethesolutiontotherefugeecrisis.Thisisamuchharderproblemtosolve,asitinvolveswhattodoinSyria,relationshipswithTurkey,orlarge-scalefinancialinterventionssuchasaso-calledMarshallPlanfortheregion.Furthermore,evenbringingpeacetoSyriawouldnoteliminatetheproblem,astherewouldstillberefugeescomingfromAfrica.Otherplans,suchassettinguprefugeecampsincountriessuchasGreeceandgivingmoremoneytorefugeecampsintheMiddleEast,astheUKiscurrentlydoing,arenecessarystepsthatshouldcomplementhisproposal.

Headdedthatwhiletheremaybesomelong-termdemographicandeconomicbenefitsfromtheinflowofrefugees,thesearelikelytobesmall.Astudyonanon-representativesampleofasylumseekersconductedbyGermany’sLabourOfficeshowedthat70%ofrefugeesareunskilledandafurther10%illiterate.Italsosaidthatthelabourparticipationrateafter5yearswillstillbebelow50percent.Thismeansthatthelong-runeconomicanddemographicbenefitsareunlikelytobelarge.

FeldalsosaidthataEuropeansolutionisneededascountriesdonotknowwhichroutetherefugeeswillchoosetocomefrom.Furthermore,astheattacksinParishaveshown,securityandtherefugeecrisisareinterlinked:someoftheattackersenteredtheEUwithoutbeingproperlycheckedattheSchengenborder.Fromanadministrativepointofview,thesolutionistoensurethatFrontexandEuropolcanactdirectly,withoutmemberstatesaskingforhelp,aninnovationthatrequirestreatychange.

Headdedthatheprefersatargetedsolutiontoagrandbargain,asthereistoomuchuncertaintyoverthecostsandeffectivenessofmeasuresaimedatsecuringtheSchengenborderinGreece.TherefugeebondsaremoreflexibleastheydonotneedtobedeployedinGreecebutcanbeusedtotackleaproblemwhereveritemerges.

Finally,FeldsaidthatitisimpossibletoblockpeopleinonepartoftheEU.Asylumseekerscanonlyfaceresidenceobligationswhentheirrequestisbeingprocessed.Oncethisisaccepted,theEU’sfreedomofmovementprinciplegivesthemtherighttomovewherevertheywant.